New Horizon for Fixed Income

January 27, 2023

The era of meager yields appears to be over.

After a prolonged era of loose monetary policy, the Federal Reserve has engaged in a sustained, aggressive campaign to raise interest rates and reduce inflation. In the wake of a global retrenchment of fixed income assets, many bonds now generate appealing income that may start to alter asset allocation views in the months and years to come.

Peak Inflation, Deceleration

Overall, our team and the market have become more comfortable with the concept that peak inflation has already arrived, with the drivers that would cause prices to decline now in place. However, the rate of deceleration is the subject of major debate. We anticipate that inflation could come down significantly this year, with a base case of around 3.5% by December 2023.

Even after a pleasing late-2022 rally, absolute yields in the market are much higher than at start of the year, and, in our view, investors can be fairly excited about potential return profiles from fixed income. The backup in rates provides something of a cushion against further upside surprises in inflation and interest rates. Although volatility has been high in the past year, we see it starting to come down.

Altogether, this more stable, higher income environment creates an appealing tableau when it comes to asset allocation decisions, which we believe may increasingly favor fixed income relative to more uncertain prospects in other asset classes.

Municipal Opportunity

Taking a look specifically at municipal markets, yields on intermediate municipals are somewhere around 3% with a three-years-plus duration (or sensitivity to interest rate fluctuations). On a tax-equivalent basis (assuming the highest federal rate of 40.8%), that comes close to a percentage point higher than the roughly 3.5% yield of the 10-year Treasury.

As we mentioned in our Solving for 2023 outlook, municipal credit quality tends to deteriorate more slowly than that of corporate bonds during tough economic times, largely because the weakness of businesses and other revenue sources must filter through to budgets before having a significant impact. This gives active managers plenty of time to adjust portfolios proactively. Stepping back, municipals remain among the most creditworthy fixed income asset classes in the world—which adds to their appeal as a place for investors to “hang out” as they wait for conditions to improve.

More Rate Exposure?

In terms of duration, we believe investors may wish to consider increasing their exposure to some degree. Yes, inflation and rates could surprise on the upside, but, all told, their direction is likely to be downward over the longer term, suggesting that this could be an opportune time to lock in higher yields before their retreat. In the context of our municipal discipline, we would look to the seven- to 12-year range of the yield curve, balanced out with some shorter assets to achieve a more modest three- to five-year average. For those who “aren’t there yet” in their optimism about interest rates, relatively high yields at the short end of the market appear to be an option.

Credit: Case by Case

Looking at credit risk, across fixed income it is likely to be more idiosyncratic going forward. Within municipals, essential service revenue bonds and tax-backed bonds are typically considered relatively resilient, but we believe individual bond and issuer fundamentals should generally be the focus.

Consider the State of California, for example. The Golden State put itself in a great position going into a tougher economic period, with a rainy-day fund that is now at its statutory limit. However, the nature of its tax system, which relies disproportionately on high earners, market activity and exercise of stock options, suggests potential headwinds—including a projected $22.5 billion budget deficit for the coming fiscal year.

In our view, 2021 was all about the “tide lifting all boats” and taking more risk where you could find it. Going forward, the environment will likely be more about the market judging each credit on its own merits. All things being equal, while we are not overly concerned about risk at this point, we are more focused on buying quality. After all, you are getting paid for buying quality on an absolute basis, compared to 2021, when yields were so low on quality bonds that investors often migrated to higher risk to generate more income.

Tailwinds for 2023?

Although interest rates appear likely to remain volatile, we see rates as generally rangebound from here, leaving investors with healthy yields across fixed income, although credit naturally will become more challenging with market weakness. The tax-advantaged yield potential of municipal fixed income, coupled with its durable credit profile, could draw new demand this year. Should the mutual fund outflows from 2022 reverse course, the asset class could see a tailwind to reinforce investor confidence.

Attractive Yield Environment

AAA Municipal Bond Yields

Chart 1  

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