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Fixed Income Monthly

By Richard "Crit" Thomas, CFA, CAIA
Income Investing
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The markets during February:  In our monthly reviews it seems that each month we are simply stating the opposite of what we said the previous month as the market rallies and then sells off, back and forth. In January bonds rallied. In February they sold off as evidence of continued labor market tightness and some disappointing inflation releases raised the odds of further U.S. Federal Reserve Board (Fed) tightening. The 10 year U.S. Treasury yield closed the month at 3.9%, up 41 basis points from the January month end. The yield on the 10 year Treasury bond has become a pivot point with all other Treasury yields of shorter or longer maturities having higher yields. Longer term yields indicate that investors believe the Fed is nearing the end of its rate hiking cycle and that the economy will slow, bringing inflation down with it.

We continue to 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 may be near the end of rate hikes, they are unlikely to reverse policy soon after. Nor are they likely to relent on their quantitative tightening. 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 90 basis points, falling from the previous month end low. 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 -2.6% during the month due mainly to the rise in interest rates. The Bloomberg U.S. High Yield Index fell 1.3% due solely to rising interest rates. High Yield credit spreads actually narrowed slightly, which was unexpected given that most risk assets sold off during the month. The Morningstar LSTA Leveraged Loan Index rose 0.6% in the month as investors shrugged off hawkish Fed concerns. 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 credit spreads and a potential attractive entry point. On the other hand, should evidence build for the prospect of a soft economic landing, we may become more positive on non-investment grade debt without a widening in credit spreads.

Thematic Backdrop

  • Interest Rate Risk: We maintained our duration posture at a moderate overweight. 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. Should inflation continue to moderate and with the Fed near a pause in rate hikes, the potential for higher yields becomes more remote. 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. The Fed has been very aggressive in raising rates, and considering the lagged effect of rate hikes, we don’t believe the full economic impact of the tightening cycle has been reached. As such the specter of default risk remains. Rating downgrades have surpassed upgrades for the first time in over one and a half years. That said, financial conditions have loosened considerably and there may be a path to a soft economic landing. Should this occur, we would get more interested in moving down in quality.
  • Fed Policy: The Fed has now raised the federal funds rate by 450 basis points. In the February statement release, the Federal Open Market Committee signaled further rate increases, though in the following press conference, Chairman Powell suggested that the downward trend in inflation could alter their policy approach. At the end of February three more 25 basis point rate increases were implied by the market. The Fed also began reducing the size of its balance sheet in June 2022. Through February the Fed’s balance sheet has shrunk by $590 billion from the peak. 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 2023 increased slightly to 0.8% according to Bloomberg. Growth estimates have increased for the first half of the year, while a significant slowdown is expected in the second half. The International Monetary Fund recently raised their global growth expectation. China’s reopening, a mild winter in Europe, and continued consumer spending strength in the U.S. all contributed. The trends are encouraging, but it is still early and the rapid pace of rate increases makes it difficult to gauge what impact this monetary tightening will have on our economy in the coming months. We continue to see a recession in 2023 as our base case, though the timing of that recession has shifted further out to possibly starting in the summer. There is a strong chance that despite recessionary conditions the Fed holds rates steady, while continuing to drain their balance sheet. That would be an uncomfortable combination for the markets (namely credit) to bear.

Recent Trends

The Yield Curve, as measured by the 10 year and 2 year Treasury yields, inverted at the start of July 2022. The 10 year Treasury yield ended the month below all maturities including the federal funds rate. The front end of the curve hooks up from 1 month to 6 months and then slopes down from there. This is consistent with current expectations that the Fed stops raising rates this summer.

The Yield Curve

Credit Spreads were mixed during the month. Investment grade bonds saw their spreads (the additional yield over duration equivalent Treasury securities) widen by 6 basis points. Meanwhile high yield spreads closed the month down just a few basis points ending the month with a spread of 412 basis points. Both investment grade and high yield spreads closed the month below their long-term historical average. This appears to underprice the risk of recession. We expect credit spreads to move higher as economic conditions weaken with a risk of recession. Should a recession occur, we do expect that it would be relatively mild. Additionally, 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, but not enough to justify a below average spread.
Credit Spreads

Absolute Yields for credit exposed securities rose during the month. The yield for the Bloomberg U.S. Corporate High Yield Index closed the month at 8.6%. Meanwhile the yield for the Bloomberg U.S. Aggregate Bond Index was 4.8% and 5.5% for investment grade corporate bonds. Investment grade yields are still near 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


We believe the biggest investment risk in fixed income today has shifted 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 become attractive and worth adding to. Though, eventually, as yields for non-investment grade debt begin to discount a recession, we are likely to start advocating for getting more risk exposure.

Positioning Considerations

  • With few exceptions fixed income securities had one of the worst downturns in 2022. 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 tight monetary policy, a potential profit margin squeeze from tight labor conditions, or an economy that may slow at a more rapid rate than expected, higher quality 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, as we expect, 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 may be a viable option. The Bloomberg Municipal Bond Index outperformed most other bond indexes in 2022. At the end of February a 5 year AAA-rated municipal bond was yielding about 63% of a 5 year Treasury note. A 10 year municipal bond currently yields 68% of the 10 year Treasury yield. State tax collections have been historically high given pandemic related stimulus measures, though more recently collections have become more mixed with state-by-state variations.

  • Looking around the corner. We believe the Fed still holds the key. While they may be near the end of raising rates, the bigger question is for how long they maintain rates at a restrictive level. The Fed’s time frame appears to be much longer than is being discounted by risk assets. Here are a few considerations.

    • Fed Chair Jerome Powell continues to suggest that the Fed is willing to sacrifice economic growth to tame inflation and is inclined to hold rates steady for an extended period to ensure they have fully extinguished inflation before lowering rates. We should take him seriously. Maintaining higher interest rates while draining their balance sheet is likely to trigger a recession. 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.

    • Should inflation fall faster than economic growth, the Fed may be able to pivot to a more easy policy stance before triggering a recession. If a recession is avoided, then default risks diminish and non-investment grade debt likely outperforms. This is not our forecast, but we are watching closely. If evidence builds that we can avoid a recession (all else equal), we are likely to move to a lower quality bias.

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            
  February 2023 YTD 2022 2021 2020 Duration Years
Bloomberg Long Term Treasury -4.7% 1.4% -29.3% -4.6% 13.6% 16.4
Bloomberg U.S. TIPS
-1.4% 0.4% -11.8% 6.0% 11.0% 7.0
Bloomberg U.S. Aggregate -2.6% 0.4% -13.0% -1.5% 7.5% 6.5
Bloomberg U.S. Agg Corporates -3.2% 0.7% -15.8% -1.0% 9.9% 7.3
Bloomberg U.S. Agg ABS -0.8% 0.6% -4.3% -0.3% 4.5% 2.9
Bloomberg U.S. Agg MBS
-2.6% 0.6% -11.8% -1.0% 3.9% 6.3
Bloomberg U.S. Agg CMBS
-1.9% 0.7% -10.9% -0.9% 8.1% 4.6
Bloomberg Municipal Bond
-2.3% 0.5% -8.5% 1.5% 5.2% 6.2
Bloomberg 1-3 year Corporate
-0.7% 0.3% -3.3% -0.1% 1.3% 1.9
ICE BofA Listed Preferreds
-1.9% 8.4% -18.1% 7.7% 8.6% NA
Bloomberg High Yield
-1.3% 2.5% -11.2% 5.3% 7.1% 4.3
Morningstar LSTA Leveraged Loan
0.6% 3.3% -0.6% 5.2% 3.1% NA
Bloomberg Global Agg
-3.3% -0.2% -16.2% -4.7% 9.2% 6.8
Bloomberg Emerging Markets USD
-2.2% 0.9% -15.3% -1.7% 6.5% 6.3

  February 2023 YTD Change bps Current Percentile 10 YR Median 10 YR Min 10 YR Max
10 year Treasury
3.9% 5 100 2.2% 0.5% 4.2%
2 year Treasury 4.8% 39


0.8% 0.1% 4.8%
10 year TIPS 1.5% -3 99 0.4% -1.2% 1.7%
Bloomberg U.S. Aggregate 4.8% 13 99 2.3% 1.0% 5.2%
Bloomberg U.S. Agg Corporate
5.5% 9 99 3.2% 1.7% 6.1%
Bloomberg U.S. Agg ABS 5.3%  15 99 1.5%   0.4% 5.7% 
Bloomberg U.S. Agg MBS 4.8%  5 99  2.8%  0.9% 5.4% 
Bloomberg U.S. Agg CMBS 5.5% 6 99  2.5% 1.4%  5.9%

Bloomberg Municipal Bond

3.6% 8 98 2.2% 0.9% 4.2%

Bloomberg 1-3 year Corporate

5.5% 26 100 1.9% 0.5% 5.8%
Bloomberg High Yield
8.6% -33 94 6.1% 3.5% 11.7%
Morningstar LSTA Leveraged Loan
9.3% 18 99 5.2% 3.6% 13.1%
Bloomberg Global Agg
3.8% 11 100 1.7% 0.8% 4.0%
Bloomberg Emerging Markets USD
7.5% 3 98 5.0% 3.5% 8.7%

Option Adjusted Spreads (bps)
YTD Change Current Percentile 10 YR Median 10 YR Min 10 YR Max
Bloomberg U.S. Corporate Agg
123 -6 54 121 80 373
Bloomberg 1-3 year Corporate 62 -10 47 66 31 390
Bloomberg U.S. Agg ABS 55 -20 63 50 22  325 
Bloomberg U.S. Agg MBS 46 -6 81 31  132 
Bloomberg U.S. Agg CMBS 113 -17 72 95 62  275
Bloomberg High Yield 412 -56 53 402 262 1100
Bloomberg Emerging Markets USD 326 -120 59 315 211 720

For Index Definitions see: TouchstoneInvestments.com/insights/investment-terms-and-index-definitions
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.
2022 – The Fed embarked on one of its most aggressive tightening paths seen in decades as the inflation rate surged well above their goal. Interest rates rose across all maturities leading to one of the worst years for fixed income returns.

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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