June was generally a good month for bond investors with a modest decline in longer term interest rates and a further tightening in credit spreads. It is unusual for interest rates to fall and credit spreads to tighten at the same time. Absent any signaling by the Federal Reserve (Fed), generally a decline in risk free interest rates is a signal of less robust economic conditions, while tighter credit spreads typically signal economic strength. A slightly more hawkish tone from the Fed, though, likely helped bring in longer term yields, while shorter term rates advanced which flattened the yield curve. Contrary to the risk free adjustments to an apparently more hawkish Fed, below investment grade credit appeared to be more influenced by economic data releases that were not too fast and not too slow. Fixed high yield outperformed floating rate loans during the month. It is likely that noisy economic data releases and the Fed continue to sow some confusion amongst investors mostly due to the inability to untangle what is temporary from what is persistent. Clarity is not likely to improve for a number of months.
Thematic Backdrop
- Interest Rate Risk: An accommodative Fed, low interest rate level and the supply/demand balance for debt suggest higher interest rate risk as the economy rebounds. We continue to suggest that investors hold duration shorter than the benchmark, but as rates rise this view will change. We believe the 10 year Treasury yield may approach (possibly surpass) 2% over the next 4-6 months as fiscal stimulus combined with the removal social distancing constraints unleashes a consumer spending spree and strong economic growth. Admittedly, the inability of the 10 year yield to definitively move up through 1.7% has us re-evaluating our assumptions.
- Credit Risk: Loose financial conditions and a recovering economy paint a picture of fewer defaults, supportive of lower quality credit securities. Current tight spreads (a measure of valuation) limits upside potential (price gains), though absolute yields remain attractive relative to higher quality credit securities. Consider adding credit exposure for more yield.
- Fed Policy: Remains accommodative with the Federal Funds rate anchored near zero and QE (quantitative easing) purchases continuing at a moderate rate. Messaging from the Federal Reserve (Fed) suggest the Federal Funds rate could remain at these levels for 2 more years. Improvements in the employment situation could accelerate this timeline. We believe a reversal in Fed policy will start with a tapering in the QE program which could come as soon as later this year.
- Economic Growth & Inflation: Consensus expectations for real U.S. GDP continue to move up, now slightly over 6.5% this year due to easy comparisons and stimulus fueled recovery spending (some estimates for GDP growth are over 7%). Inflation has risen well beyond that Fed’s 2% average target, as we have come up against easy comparisons just as the economy reopens and more fiscal stimulus hits. Looking out to 2022 we expect inflation to moderate (potentially back toward 2%) when comparisons get more difficult, stimulus wanes, and economic growth begins to normalize. Consensus estimates for inflation have also increased due to expected lingering supply issues and tighter than expected labor market conditions.
Recent Trends
The Yield Curve has begun to ease over the last 2 months as long-term rates have slipped while short-term rates have moved up slightly. We measure the yield curve by taking the difference between the 10 year Treasury yield and the 2 year Treasury yield, though other combinations of long and short maturities can be used. While longer term rates have moved up, they remain quite low in a historical context. Given expectations for a significant increase in economic growth and inflation (in the near-term), the yield curve begin to steepen again later this year.
Source: Bloomberg
Credit Spreads have narrowed. It is becoming harder to justify credit exposure simply based on the credit spread (the additional yield over duration equivalent Treasuries) as we’ve plumbed the lows of the last cycle. This suggests limited price gains from here (exclusive of duration exposure). There are essentially two ways to make money from a credit security – coupon income and security price changes. Just because the opportunity for price gains are more limited, doesn’t mean that credit exposure is not justified as the income component remains attractive relative to risk free bonds.
Source: Bloomberg
Absolute Yields for credit exposed securities remain historically low. And the yield advantage of below investment grade bonds over investment grade bonds has narrowed over the last year mainly due to lower yields for below investment grade bonds. Still lower quality bonds offer an additional 2.5 percentage points in yield over higher quality bonds (as measured by the Bloomberg Barclays U.S. Corporate High Yield and Bloomberg Barclays U.S. Corporate Aggregate Bond index). If one were to simply earn the yield difference that would lead to significant outperformance on either a 3 or 5 year time frame. Additionally the investment grade index continues to face more interest rate risk (due to a higher duration) than the high yield index (with a much lower duration).
Source: Bloomberg
Risks/Opportunities
We believe the biggest investment risk in fixed income today is related to real returns. With interest rates so low and inflation expected to remain above the Fed’s 2% target for some time, investors are likely to struggle to maintain spending power through their fixed income allocation. Related to this risk is the potential for longer term rates to continue rising with expectations for higher economic growth and inflation. This duration risk is amplified by near record high duration for the Bloomberg Barclays U.S. Aggregate index (Agg).
Positioning Considerations
- The fixed income marketplace presents a difficult backdrop of rising rates and narrow credit spreads. We believe that investors consider a more active and flexible strategy that could take advantage of mispriced sectors and rapidly changing market conditions.
- For those that are concerned about either rising inflation or rising interest rates we suggest investors consider strategies that have a lower than benchmark duration and/or increased exposure to sectors with higher credit risk. Why consider adding credit risk? Economic expansion typically means lower defaults, which is the greatest risk for credit securities. Spreads may not narrow any more, but the absolute yield looks relatively attractive. Additionally through an active strategy one may be able to access bond categories that sit outside of the Agg benchmark that are investment grade, yet carry more attractive yields (e.g. Preferreds).
- Looking around the corner. Visibility is low as we don’t know how high rates will go, the Fed’s response, or what rate of growth the economy will settle into post the pandemic boom. Here are a few considerations. Right now we are positioning for the expected economic rebound boom. Once we get further into this recovery boom, we believe investors should begin thinking about positioning for the post boom period. Depending on how high interest rates go, moving out the curve would be a definite consideration – we would be adding duration if the 10 year Treasury yield gets near 2%. Maintaining credit exposure should continue to provide higher income and a stable price environment as long as the labor market and financial conditions remain loose. That said there is a risk on the horizon for credit when the Fed begins to signal a need to raise the Federal Funds rate. The Fed will be watching the labor market first and inflation data secondarily to determine when to make that shift. The Fed doesn’t believe they will need to consider changing their interest rate stance until late 2023. In the last economic expansion cycle, which started in 2009, the Fed waited more than 6 years before they started to raise interest rates.
Fixed Income Indexes Characteristics
The Indexes mentioned are unmanaged statistical composites of stock market or bond market performance. Investing in an index is not possible.
| Total Returns |
|---|
| June 2021 | YTD | 2020 | 2019 | 2018 | Duration Years | |
|---|---|---|---|---|---|---|
| Bloomberg Barclays 10-20 year Treasury | 3.0% | -7.2% | 13.6% | 11.0% | 0.0% | 15.2 |
| Bloomberg Barclays U.S. TIPS |
0.6% | 1.7% | 11.0% | 8.4% | -1.3% | 7.6 |
| Bloomberg Barclays U.S. Aggregate | 0.7% | -1.6% | 7.5% | 8.7% | 0.0% | 6.6 |
| Bloomberg Barclays U.S. Agg Corporates | 1.6% | -1.3% | 9.9% | 14.5% | -2.5% | 8.5 |
| Bloomberg Barclays ABS | 0.0% | 0.2% | 4.5% | 4.5% | 1.8% | 2.0 |
| Bloomberg Barclays MBS |
0.0% | -0.8% | 3.9% | 6.4% | 1.0% | 4.5 |
| Bloomberg Barclays CMBS |
0.2% | -0.5% | 8.1% | 8.3% | 0.8% | 5.2 |
| Bloomberg Barclays Municipal Bond |
0.3% | 1.1% | 5.2% | 7.5% | 1.3% | 4.8 |
| Bloomberg Barclays 1-3 year Corporate |
-0.1% | 0.2% | 1.3% | 2.7% | 2.0% | 1.8 |
| ICE BofA Listed Prefereds |
1.8% | 4.6% | 8.6% | 18.5% | -3.8% | NA |
| Bloomberg Barclays High Yield |
1.3% | 3.6% | 7.1% | 14.3% | -2.1% | 3.7 |
| S&P/LSTA Leveraged Loans |
0.4% | 3.3% | 3.1% | 8.6% | 0.4% | 0.0 |
| Bloomberg Barclays Global Agg |
-0.9% | -3.2% | 9.2% | 6.8% | -1.2% | 7.5 |
| Bloomberg Barclays Emerging Markets USD |
0.7% | -0.6% | 6.5% | 13.1% | -2.5% | 7.0 |
| Yields |
|---|
| June 2021 | YTD Change bps | 10 YR Current Percentile | 10 YR Median | 10 YR Min | 10 YR Max | |
|---|---|---|---|---|---|---|
| 10 year Treasury |
1.5% | 55 | 11 | 2.1% | 0.5% | 3.2% |
| 2 year Treasury | 0.2% | 13 | 18 | 0.6% | 0.1% | 3.0% |
| 10 year TIPS | -0.9% | 21 | 6 | 0.3% | -1.1% | 1.2% |
| Bloomberg Barclays U.S. Aggregate | 1.5% | 38 | 11 | 2.3% | 1.0% | 3.7% |
| Bloomberg Barclays Corporate |
2.0% | 30 | 7 | 3.2% | 1.7% | 4.6% |
| Bloomberg Barclays Municipal Bond |
1.0% | -7 | 2 | 2.2% | 0.9% | 3.5% |
| Bloomberg Barclays High Yield |
3.7% | -44 | 1 | 6.2% | 3.9% | 11.7% |
| S&P/LSTA Leveraged Loans |
3.7% | -28 | 23 | 4.9% | 2.4% | 10.1% |
| Bloomberg Barclays Global Agg |
1.1% | 29 | 12 | 1.7% | 0.8% | 2.8% |
| Bloomberg Barclays Emerging Markets USD |
3.8% | 31 | 4 | 5.0% | 3.5% | 7.9% |
| Option Adjusted Spreads (bps) |
|---|
| June 2021 | YTD Change | 10 YR Current Percentile | 10 YR Median | 10 YR Min | 10 YR Max | |
|---|---|---|---|---|---|---|
| Bloomberg Barclays U.S. Corporate Agg |
80 | -16 | 1 | 128 | 80 | 373 |
| Bloomberg Barclays 1-3 year Corporate | 31 | -4 | 1 | 73 | 31 | 390 |
| Bloomberg Barclays High Yield | 267 | -92 | 1 | 435 | 265 | 1100 |
| S&P/LSTA Leveraged Loans | 344 | -18 | 43 | 352 | 167 | 994 |
| Bloomberg Barclays Emerging Markets USD |
271 | -3 | 15 | 316 | 211 | 720 |
2018 – The Fed was tightening (raising rates). Credit sold off (economically sensitive) and Interest rates moved up.
2019 – The Fed stopped tightening and then began to ease. Everything rallied, recession risk diminished and rates moved down (likely due to US/China trade war risk and foreign buying).
2020 – Pandemic. Fed in massive stimulus mode. Interest rates dropped precipitously. Credit rallied after Fed started buying junk bonds and fiscal stimulus measures appeared to be more than enough to offset economic downturn.
Glossary of Investment Terms & Index Definitions
This commentary is for informational purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security. There is no guarantee that the information is complete or timely. Past performance is no guarantee of future results. Investing in an index is not possible. Investing involves risk, including the possible loss of principal and fluctuation of value. Please visit touchstoneinvestments.com for performance information current to the most recent month-end.
A Word About Risk
Investing in fixed-income securities which can experience reduced liquidity during certain market events, lose their value as interest rates rise and are subject to credit risk which is the risk of deterioration in the financial condition of an issuer and/or general economic conditions that can cause the issuer to not make timely payments of principal and interest also causing the securities to decline in value and an investor can lose principal. When interest rates rise, the price of debt securities generally falls. Longer term securities are generally more volatile. Investment grade debt securities which may be downgraded by a Nationally Recognized Statistical Rating Organization (NRSRO) to below investment grade status. U.S. government agency securities which are neither issued nor guaranteed by the U.S. Treasury and are not guaranteed against price movements due to changing interest rates. Mortgage-backed securities and asset-backed securities are subject to the risks of prepayment, defaults, changing interest rates and at times, the financial condition of the issuer. Foreign securities carry the associated risks of economic and political instability, market liquidity, currency volatility and accounting standards that differ from those of U.S. markets and may offer less protection to investors. Emerging markets securities which are more likely to experience turmoil or rapid changes in market or economic conditions than developed countries.
Performance data quoted represents past performance, which is no guarantee of future results. The investment return and principal value of an investment in the Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than performance data given. For performance information current to the most recent month-end, visit TouchstoneInvestments.com/mutual-funds.
Please consider the investment objectives, risks, charges and expenses of the fund carefully before investing. The prospectus and the summary prospectus contain this and other information about the Fund. To obtain a prospectus or a summary prospectus, contact your financial professional or download and/or request one on the resources section or call Touchstone at 800-638-8194. Please read the prospectus and/or summary prospectus carefully before investing.
Touchstone Funds are distributed by Touchstone Securities, Inc.*
*A registered broker-dealer and member FINRA/SIPC.
Not FDIC Insured | No Bank Guarantee | May Lose Value
