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Fixed Income Monthly

By Richard "Crit" Thomas, CFA, CAIA
Income Investing
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The markets during October:  Continued signs of “core” inflationary pressure caused investors to re-evaluate the terminal federal funds rate higher. Rates across the U.S. Treasury maturity curve moved higher during the month. The 10 year Treasury yield closed the month with a 4.05% yield. For the first time in this rate hiking cycle the 3 month Treasury yield surpassed the yield on the 10 year Treasury. We believe the market may be getting too pessimistic about where the U.S. Federal Reserve Board (Fed) will take rates. Currently the markets are implying another 200 basis points, which would take the federal funds rate to just over 5%. We believe the Fed begins to slow and then pause before they get to 5% as we anticipate confirming signs of weakening economic conditions and less inflationary pressure to begin showing up in early 2023. But if inflation remains more sticky, then the terminal rate is likely to surpass 5% and bring with it more economic pain.

That said, as we’ve stated in the past we believe that the Fed does not want to make the mistake made in the 1970s and is unlikely to relent in their efforts to bring inflation down to their 2% target. While the Fed is likely to slow the pace of rate increases and then pause sometime in 2023, they are unlikely to reverse policy soon after. We believe they will need strong evidence that inflationary drivers have been fully doused before shifting toward a more accommodative stance. The current pace and magnitude of rate increases have surpassed many past tightenings. This rapid pace and the typical lagged effect of rate increases does create uncertainty over just how much economic damage they have already set in motion.

The yield curve, as measured by the 10 and 2 year U.S. Treasury bond yields, was inverted by 43 basis points, unchanged from the previous month end. Historically yield curve inversions have been reliable predictors of a coming recession. We take this signal seriously, though as mentioned in the past, should we fall into a recession we believe it should be relatively mild. It is notable that we have not found any historical relationship between the depth of a yield curve inversion and the depth of the ensuing recession, only that there was an inversion indicating a coming recession was important.

The investment grade corporate bond portion of the Bloomberg U.S. Aggregate Bond Index returned -1.3% during the month due to rising interest rates and widening credit spreads. The Bloomberg U.S. High Yield Index rallied 2.6%. High Yield Credit spreads narrowed by 89 basis points. The S&P/LSTA Leveraged Loan Index rose 1.0% in the month due to yield income. We continue to emphasize higher credit quality, though we are looking for an opportunity to begin adding lower quality exposure. We believe the Fed will be successful at slowing economic growth which should lead to wider spreads and a potential attractive entry point.

Thematic Backdrop

  • Interest Rate Risk: We increased our duration posture to a moderate overweight last month after the 10 year Treasury yield tested 4%. The language and tone coming from the Fed is indicating much greater resolve to tame inflation. That combined with higher yields gave us the impetus to increase our duration positioning. We are not necessarily calling for a top in yields, but believe we are close and would add more duration if yields move higher. Fed rate hiking cycles typically resolve themselves with much lower interest rates (eventually) creating reinvestment risk for short duration bonds and greater capital gain potential for longer duration bonds.
  • Credit Risk: We are emphasizing a quality bias in credit positioning. Financial conditions have begun to tighten as indicated by a reluctance of banks wanting to own corporate debt and low issuance. Dealer inventories of corporate debt are very low, especially high yield as reported by the Fed. We also believe that the Fed will be successful at slowing the economy, raising the specter of default risk. That said, wider high yield credit spreads would get us more interested in moving down in quality.
  • Fed Policy: The Fed has now raised the federal funds rate by 300 basis points, and appears to be on track to add another 125-175 basis points by the end of the year. They next meet in November and market expectations are for another 75 basis point increase. The Fed also began reducing the size of its balance sheet on June 1. The Fed faces a difficult landscape with both demand and supply side inflation drivers. The risk of making a mistake by being either too aggressive or too lenient remains high, though its messaging continues to suggest that it is willing to err on the side of too aggressive.
  • Economic Growth & Inflation: Consensus expectations for real U.S. GDP growth in 2022 have stabilized. The consensus is currently at 1.7% for 2022 according to Bloomberg. Shifting our focus out to 2023 consensus expectations dropped to 0.4% GDP growth with inflation running just over 3%. The rapid pace of rate increases makes it difficult to gauge what impact this monetary tightening will have on our economy, only that it won’t be good. We expect that the first half of 2023 could hold recessionary conditions. While that will likely halt the rate increases, the Fed will likely pay closer attention to inflation as opposed to economic growth. There is a strong chance that despite recessionary conditions the Fed holds rates steady. That would be an uncomfortable combination for the markets (namely credit) to bear.

Recent Trends

The Yield Curve inverted at the start of July. We had assumed that the yield curve would eventually invert, as the Fed continues to push up shorter term rates and evidence of slowing economic growth holds longer term rates steady (or move down). An inverted yield curve has typically been a precursor to a recession. 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. The 10 year Treasury yield is currently below all shorter term maturities other than those less than 3 months.

The Yield Curve Chart

Credit Spreads narrowed during the month. We expect credit spreads (the additional yield over duration equivalent Treasury securities) to move higher as economic conditions weaken with a high risk of recession. Typically, during a recession, high yield spreads get well above 900 basis points. We don’t believe they will get that high this time if we go into a recession. If they do, we believe it would be a great buying opportunity. The high yield index has a much higher quality rating mix than in the past. And there is no maturity wall facing higher yielding bonds; more like a maturity curb. According to Bloomberg just 8% of non-investment grade bonds are coming due before 2024. These factors suggest fewer defaults than would be typical during a recession.

Credit Spreads Chart

Absolute Yields for credit exposed securities were mixed. The yield for the Bloomberg U.S. Corporate High Yield Index closed the month at 9.1%. Meanwhile the yield for the Bloomberg U.S. Aggregate Bond Index was 5.0% and 5.9% for investment grade corporate bonds. Investment grade yields are at the highest level seen since 2009. The greater safety of the investment grade indexes and now higher absolute yield does make them look more attractive with a backdrop of slowing economic growth and a Fed that is willing to sacrifice economic growth to tame inflation.

Absolute Yields Chart

Risks/Opportunities

We believe the biggest investment risk in fixed income today is shifting from inflation to economic weakness. In other words from interest rate risk to credit risk. Risk free rates have moved up significantly, though real rates are still negative meaning that investors continue to lose spending power from the income generated. But, we believe that this will correct itself over time with the rate of inflation expected to fall. The rising risk is economic weakness and tighter lending conditions which are likely to create headwinds for more economically sensitive credit securities. We believe leveraged loans are more at risk as they will be forced to adjust automatically to the higher rates. From an opportunity standpoint, investment grade yields have moved up while economic growth and inflation are expected to slow later this year. After a brutal start to the year it may be time to consider adding to both duration and quality. Though, eventually, as yields for non-investment grade debt begin to discount a recession, we are likely to start advocating for getting more exposure.

Positioning Considerations

  • With few exceptions fixed income securities have had one of the worst downturns in decades. Uncertainty still prevails given cross currents of pandemic recovery, war in Ukraine, high inflation, accelerated monetary policy tightening, and slowing economic growth. Yet we believe parts of the fixed income marketplace have adjusted (painfully) to these less promising conditions, namely within the investment grade universe. With heightened risks of a more aggressive Fed, a profit margin squeeze from tight labor conditions, or an economy that may slow at a more rapid rate than expected, fixed income may provide ballast to a portfolio given higher current interest rates. We believe that investors should consider a more active and flexible strategy that could take advantage of mispriced sectors and rapidly changing market conditions.

  • For those investors concerned about either stubbornly high inflation or rising interest rates we suggest considering strategies that have a lower than benchmark duration. That said, should inflation and economic growth slow, current long-term interest rates are likely to outperform the very short end of the curve. Additionally, through an active strategy one may be able to access bond categories that sit outside of the Bloomberg U.S. Aggregate benchmark that are investment grade, yet carry more attractive yields.

  • For tax aware investors municipal bonds have become more attractive from a relative yield perspective. The Bloomberg Municipal Bond Index has outperformed the Bloomberg U.S. Treasury Index year-to-date despite similar risk profiles. The Bloomberg Municipal Bond Index started the year with a lower duration, helping relative performance, though currently now has a slightly higher duration than the Bloomberg US Treasury Index. At the start of this year a 5 year AAA-rated municipal bond was yielding about 47% of a 5 year Treasury note. At the end of October it was 77%. A 10 year municipal bond started the year with a yield that was 77% of a 10 year Treasury and has now moved up to 85% (earlier in May it got over 100%). Tax rates haven’t increased, so a taxable investor is now getting much more absolute and relative yield (relative to Treasuries) than at the start of the year. Municipals also fit in with our quality bias. State tax collections are historically high given pandemic related stimulus measures. State tax collections in 2021 were 20% higher than in 2019. And 2022 looks likely to be another strong year which would suggest municipal credit is in a strong position should we go into a recession.

  • Looking around the corner. Visibility is low as we still don’t know whether the Fed will push our economy into a recession, but it does seem likely. The war in Ukraine further complicates the outlook. Here are a few considerations.

    • Fed Chair Jerome Powell continues to suggest that the Fed is willing to sacrifice economic growth to tame inflation. We should take him seriously. Recessionary conditions are typically beneficial for those positioned in higher quality and longer duration bonds.

    • Should we fall into a recession we do believe it will be mild as we have not built up credit excesses that typically aggravate an economic downturn. That combined with a low maturity wall for non-investment grade bonds, should result in a more moderate rise in defaults. We are likely to come back to high yield bonds as spreads widen. We may begin to adjust our positioning if spreads widen beyond 600 basis points.

    • Looking out further into 2023 the visibility gets even worse, but it will be important to consider how the Fed responds to recessionary conditions. It is likely that the rate of inflation will be coming down, but still remain well above their target. Does the Fed simply just stop tightening or do they begin to ease? Currently the market is forecasting that they begin to ease. We think it will depend on where inflation is and how rapidly it is falling as well as what is happening in the labor market. It is too early to speculate, but given the Powell speech at Jackson Hole, it appears that they are inclined to hold rates steady for an extended period to ensure that they have fully extinguished inflation before reducing 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            
  October 2022 YTD 2021 2020 2019 Duration Years
Bloomberg Long Term Treasury -5.5% -32.8% -4.6% 13.6% 11.0% 16.3
Bloomberg U.S. TIPS
1.2% -12.5% 6.0% 11.0% 8.4% 6.9
Bloomberg U.S. Aggregate -1.3% -15.7% -1.5% 7.5% 8.7% 6.3
Bloomberg U.S. Agg Corporates -1.0% -19.6% -1.0% 9.9% 14.5% 7.2
Bloomberg U.S. Agg ABS -0.8% -5.9% -0.3% 4.5% 4.5% 2.8
Bloomberg U.S. Agg MBS
-1.4% -14.9% -1.0% 3.9% 6.4% 6.2
Bloomberg U.S. Agg CMBS
-1.6% -13.2% -0.9% 8.1% 8.3% 4.7
Bloomberg Municipal Bond
-0.8% -12.9% 1.5% 5.2% 7.5% 6.9
Bloomberg 1-3 year Corporate
-0.2% -4.8% -0.1% 1.3% 2.7% 2.0
ICE BofA Listed Preferreds
-3.0% -19.1% 7.7% 8.6% 18.5% NA
Bloomberg High Yield
2.6% -12.5% 5.3% 7.1% 14.3% 4.5
S&P/LSTA Leveraged Loan
1.0% -2.3% 5.2% 3.1% 8.6% NA
Bloomberg Global Agg
-0.7% -20.4% -4.7% 9.2% 6.8% 6.8
Bloomberg Emerging Markets USD
-0.9% -21.2% -1.7% 6.5% 13.1% 6.1


Yields
  October 2022 YTD Change bps Current Percentile 10 YR Median 10 YR Min 10 YR Max
10 year Treasury
4.0% 254 100 2.2% 0.5% 4.2%
2 year Treasury 4.5% 375 100 0.7% 0.1% 4.6%
10 year TIPS 1.5% 264 100 0.3% -1.2% 1.7%
Bloomberg U.S. Aggregate 5.0% 326 100 2.3% 1.0% 5.2%
Bloomberg U.S. Agg Corporate
5.9% 360 100 3.1% 1.7% 6.1%
Bloomberg U.S. Agg ABS 5.5%  433 100 1.5%   0.4% 5.5% 
Bloomberg U.S. Agg MBS 5.1%   313 100  2.7%  0.9% 5.4% 
Bloomberg U.S. Agg CMBS 5.7%  379 100  2.4% 1.4%  5.8%
Bloomberg Municipal Bond
4.2% 310 100 2.2% 0.9% 4.2%
Bloomberg High Yield
9.1% 490 97 6.0% 3.5% 11.7%
S&P/LSTA Leveraged Loan
8.6% 469 99 5.2% 3.6% 13.1%
Bloomberg Global Agg
3.8% 251 100 1.7% 0.8% 4.0%
Bloomberg Emerging Markets USD
8.5% 419 100 5.0% 3.5% 8.7%

Option Adjusted Spreads (bps)
  October
2022
YTD Change Current Percentile 10 YR Median 10 YR Min 10 YR Max
Bloomberg U.S. Corporate Agg
158 65 91 122 80 373
Bloomberg 1-3 year Corporate 100 58 93 66 31 390
Bloomberg U.S. Agg ABS 91 53 98 49 22  325 
Bloomberg U.S. Agg MBS 73 42 99 31  132 
Bloomberg U.S. Agg CMBS 142 66 91 95 62  275
Bloomberg High Yield 462 180 69 404 262 1100
Bloomberg Emerging Markets USD 414 94 93 311 211 720

For Index Definitions see: TouchstoneInvestments.com/insights/investment-terms-and-index-definitions
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.
2021 – Pandemic continued in waves. Fed held rates near zero and continued to grow its balance sheet at a moderate pace. Long duration bonds sold off while Treasury Inflation Protected Securities rallied on inflation concerns. Exclusive of duration credit exposed securities generally earned their yield.

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.
Touchstone is a member of Western & Southern Financial Group

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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