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Fixed Income Monthly

By Richard "Crit" Thomas, CFA, CAIA
Income Investing
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Since the last edition: Long term bond yields marched higher in September. The Bloomberg 10-20 year Treasury index sold off 2.6% in the month. It is hard to tell what the catalyst was, possibly concerns over an impending taper, the debt ceiling, or maybe it was continued anecdotal news flow of rising input costs and wages. The 10 year Treasury yield closed out the month at 1.5% rising almost 20 basis points over the month. The Bloomberg U.S. Aggregate index with a duration of 6.7 years dropped 0.9%. Meanwhile below investment grade credit fixed rate securities held flat while floating rate bonds advanced. While we anticipate long term yields move higher we decided to revisit our inflation forecast. The Delta variant has prevented a full return to normalcy which will likely lead to an extended period of higher prices. But we don’t believe it evolves into a new inflationary regime. At least not yet. This pandemic set off a reduction in the supply of consumer facing services. Fiscal stimulus gave us money to spend and we did. On goods. This created a goods supply/demand imbalance. This imbalance, along with virus related shutdowns, created massive supply chain issues. The Delta variant has stunted our ability to fully reopen the supply of services and is likely a cause for the muted return of job seekers. But we are reopening the services sector which should take some pressure off goods, and the fiscal stimulus tap has mostly closed. We are heading in the right direction, but we probably won’t get all the way back to normal. Wage gains are very difficult to reverse. So far, they have mainly impacted lower wage jobs, which have less of an overall economic impact. But should they broaden out into the higher income spectrum we will have to revisit our thesis.

Thematic Backdrop

  • Interest Rate Risk: We continue to suggest that investors hold duration slightly shorter than the benchmark. Our relative value model suggests the 10 year Treasury yield should currently be in a range of 1.50%- 1.75%. Looking out into 2022 and 2023 we see the potential for yields to move toward 2%.

  • Credit Risk:Loose financial conditions and a recovering economy have led to ratings upgrades and fewer defaults, supportive of lower quality credit securities. Yet increasingly tight spreads (a measure of valuation) limits upside potential (price gains). Absolute yields do remain attractive relative to higher quality credit securities, though as spreads tighten we believe investors should become more selective. Consider adding credit exposure for more yield where valuations allow.
  • 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 Fed suggest that they could begin tapering purchases at the November meeting. The new Federal Funds dot plot puts 2022 in the cards for a rate increase, though we expect that they will wait until sometime in 2023.
  • Economic Growth & Inflation: Consensus expectations for real U.S. GDP are currently for 5.9% in 2021 due to easy comparisons and stimulus fueled recovery spending. Estimates for the second half have shifted down slightly due to the Delta variant. Inflation has risen well beyond the Fed’s 2% average target due to a combination of both supply and demand pressures. At this time the data is inconclusive as to how much of this rise in inflation will persist into 2022 and beyond. We believe economic growth and inflation will moderate in 2022 when comparisons get more difficult and services spending increases at the sacrifice of goods. Evidence of higher wage growth penetration in higher paying industries and sectors could change our view

Recent Trends

The Yield Curve has begun to move back up after a significant reversal earlier this year. 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 are higher than a year ago, they remain quite low in a historical context. The yield curve acts as a market gauge for expected economic growth, and the upward shape of the curve suggests moderate growth expectations.

graph

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. That said as prices rise we believe investors should become more selective and valuation aware.

Fixed Income

Source: Bloomberg

Absolute Yields or 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 2.7 percentage points in yield over higher quality bonds (as measured by the Bloomberg U.S. Corporate High Yield and Bloomberg U.S. Corporate Aggregate Bond index). If one were to simply earn the yield difference that could lead to meaningful 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).

Fixed Income

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 begin to rise again should economic growth and/or inflation surprise on the upside. This duration risk is amplified by near record high duration for the Bloomberg U.S. Aggregate index (Agg).

Positioning Considerations

  • The fixed income marketplace presents a difficult backdrop of low interest 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 further, 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.

  • Looking around the corner. Visibility is low as we don’t know when or how aggressively the Fed’s stimulus removal will be, or what rate of growth the economy will settle into post the pandemic boom. Here are a few considerations. Right now we believe investors are beginning to look beyond this current economic rebound boom and consider what lies beyond. Depending on whether interest rates go higher, moving out the curve would be a definite consideration – we would consider adding duration if the 10 year Treasury yield gets above a 1.6%-1.7% range. 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. We don’t believe this is a near-term risk. But this cycle is very different and a more rapid recovery path could advance the timeline. Given how narrow spreads have become in places within the credit universe we have begun to advocate a more selective approach and an emphasis on quality where valuations allow.

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            
  SEPTEMBER 2021 YTD 2020 2019 2018 Duration Years
Bloomberg 10-20 year Treasury -2.6% -6.8% 13.6% 11.0% 0.0% 15.3
Bloomberg U.S. TIPS
-0.7% 3.5% 11.0% 8.4% -1.3% 7.9
Bloomberg U.S. Aggregate -0.9% -1.6% 7.5% 8.7% 0.0% 6.7
Bloomberg U.S. Agg Corporates -1.1% -1.3% 9.9% 14.5% -2.5% 8.7
Bloomberg ABS -0.1% 0.2% 4.5% 4.5% 1.8% 2.2
Bloomberg MBS
-0.4% -0.7% 3.9% 6.4% 1.0% 4.5
Bloomberg CMBS
-0.8% -0.5% 8.1% 8.3% 0.8% 5.1
Bloomberg Municipal Bond
-0.7% .8% 5.2% 7.5% 1.3% 4.8
Bloomberg 1-3 year Corporate
0.0% 0.4% 1.3% 2.7% 2.0% 1.8
ICE BofA Listed Prefereds
0.7% 4.9% 8.6% 18.5% -3.8% NA
Bloomberg High Yield
0.0% 4.5% 7.1% 14.3% -2.1% 3.8
S&P/LSTA Leveraged Loans
0.6% 4.4% 3.1% 8.6% 0.4% 0.0
Bloomberg Global Agg
-1.8% -4.1% 9.2% 6.8% -1.2% 7.5
Bloomberg Emerging Markets USD
-1.7% -1.1% 6.5% 13.1% -2.5% 7.1


Yields
  August 2021 YTD Change bps Current Percentile 10 YR Median 10 YR Min 10 YR Max
10 year Treasury
1.5% 57 14 2.1% 0.5% 3.2%
2 year Treasury 0.3% 15 26 0.6% 0.1% 3.0%
10 year TIPS -0.9% 20 8 0.3% -1.2% 1.2%
Bloomberg U.S. Aggregate 1.6% 44 14 2.3% 1.0% 3.7%
Bloomberg Corporate
2.1% 38 11 3.1% 1.7% 4.6%
Bloomberg Municipal Bond
1.1% 5 7 2.2% 0.9% 3.5%
Bloomberg High Yield
4.0% -14 5 6.1% 3.5% 11.7%
S&P/LSTA Leveraged Loans
3.7% -27 1 4.8% 1.8% 10.1%
Bloomberg Global Agg
1.2% 34 18 1.7% 0.8% 2.6%
Bloomberg Emerging Markets USD
4.2% 70 14 5.0% 3.5% 7.9%

Option Adjusted Spreads (bps)
  August 2021 YTD Change Current Percentile 10 YR Median 10 YR Min 10 YR Max
Bloomberg U.S. Corporate Agg
84 -12 1 126 80 373
Bloomberg 1-3 year Corporate 32 -3 1 70 31 390
Bloomberg High Yield 287 -72 2 426 262 1100
S&P/LSTA Leveraged Loans 193 -169 1 351 128 994
Bloomberg Emerging Markets USD
300 34 32 315 211 720


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

crit thomas global market strategist

Richard "Crit" Thomas, CFA, CAIA

Global Market Strategist
Crit is responsible for examining and evaluating economic conditions, generating insights and providing a sharpened perspective on investment strategies for enriched portfolio construction.

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