Positioning Bonds For A Peak In Interest Rates


What started as a decent comeback for fixed income in 2023 has now largely fizzled out following the most recent move higher in long-term interest rates. While the investment team at MAI believes that bonds play an important role in portfolios requiring stability and income generation, it has been a frustrating 18 months in terms of returns.

Why Are Bond Yields Continuing to Rise?

There are a number of reasons that bond yields have continued to move higher in this market, even as inflation continues to slow. The increase in the US Federal Funds Rate from effectively zero in early 2022 to above 5% now has driven the 10-year Treasury yield to its highest level since 2007 and has led to difficult returns in the bond market, but that is not the only factor exerting upward pressure on bond yields.

Source: Bloomberg, 9/27/23    Past performance is not indicative of future returns.  This should not be considered a recommendation to buy or sell any security.

Growth expectations have increased because of the resiliency in the labor market and the notion that the US economy could experience a soft landing. As a result, real yields, which are a proxy for growth expectations and one component of Treasury yields, have risen in recent quarters.

Another component of yields is the term premium, or the added compensation investors require to lend over extended periods of time or to take more credit risk. Term premiums can also be viewed as any factor not related to growth or inflation expectations that impact the required yield for bond investors. 

The US fiscal situation has been a focus of late, particularly after Fitch Ratings downgraded the AAA credit rating of the US by one notch over the summer. Not only has the fiscal picture deteriorated as interest costs and deficits have risen, but US Treasury issuance has been significant as the Treasury refilled its general account after the debt ceiling deal in July. That added supply in the market paired with a worsening fiscal situation has pushed the term premium, and thus bond yields, higher of late.

Furthermore, rates are not only rising in the US. Other major central banks are combatting inflation by increasing rates as well. For example, even the Bank of Japan, which has waged a longstanding battle against deflation, has begun easing its yield curve controls.  Markets are now projecting the central bank could potentially end its negative interest rate policy as early as next year. As a result, this hawkishness from major central banks has acted as a rising tide for bond yields not just in the US, but globally as well.

Has the Fed Funds Rate Peaked?

There are a couple important viewpoints here. At the September FOMC meeting, Chair Powell indicated that additional tightening might be necessary to further slow inflation.  The most recent dot plot corroborates that assertion and is currently projecting the expectation for one more 25-basis point hike by the end of this year with rate cuts beginning in 2024.

Source: Bloomberg, 9/27/23

The market, on the other hand, is a little more skeptical – only pricing in about a 50% chance of a 25-basis point increase this year and a shallower path of rate cuts than what the dots imply. This view is more consistent with the current soft-landing narrative.

We believe the answer to the peak rate question really depends on whether the neutral rate of interest has moved structurally higher. The neutral rate is the level of interest rates that is considered neither restrictive nor accommodative in terms of economic output. Some have speculated that the neutral rate may have moved higher in recent years, which could mean that interest rates may not be as restrictive as policymakers think. If that is true, then rates may need to remain elevated longer than investors currently expect or potentially move higher than what is currently priced into the market. While difficult to observe the neutral rate in real time, one market proxy to watch is the five-year, five-year Treasury forward. That measure has clearly trended higher since 2020, currently nearing 4.5%, a full 2% higher than the FOMC’s median longer-run estimate of the fed funds rate.

Overall, we believe the peak in rates may be close, but there are reasons to believe that rates could remain elevated for longer than what is currently expected.

How has MAI Adjusted to Higher Rates?

MAI has gotten more defensive within the fixed income asset class. As a firm, we believe that the net effect of rate increases has yet to fully make its way through the economy, and despite talk of a soft landing, recession risk should remain elevated over the next 12-18 months.

There are two primary ways that MAI has taken a more defensive stance in bond portfolios.

First, we have incrementally added duration exposure as rates have risen. While it is difficult to definitively say when the last rate increase for this cycle will occur, history has shown that bond yields tend to peak around the time of the final hike. Increased duration exposure should benefit bondholders in the event of an economic slowdown, and Chair Powell has guided that a period of below-trend economic growth will be required to slow inflation to the Fed’s 2% target.

Secondly, we have scaled back credit risk in portfolios by moving up in quality, essentially favoring investment-grade credit over higher yielding sectors. One interesting piece about this rate cycle is that credit has continued to perform well despite both monetary policy and financial conditions tightening, in addition to credit fundamentals beginning to deteriorate. With credit spreads sitting below historical averages, MAI has reduced positions in higher yielding sectors like Emerging Market Debt and Floating Rate Bank Loans in favor of higher quality, investment-grade bonds that should be more resilient in a worsening or more difficult economic environment. 

MAI takes a very conservative and measured stance towards fixed income investing, focusing on stability and capital preservation, and these moves are consistent with that mindset.

If you have any questions related to this topic or your portfolio in general, please do not hesitate to reach out to your wealth advisor at any time.

Please send your questions, comments, and feedback to: Any statement non-factual in nature constitutes only current opinion of this author which is subject to change without notice. Certain statements are of future expectations and other forward-looking statements are based on management’s current views and assumptions. Any statistics mentioned have been obtained from sources we believe to be reliable, but the accuracy and completeness of the information cannot be guaranteed. Neither the information nor any views expressed should be considered investment, legal or tax advice, or constitute as a recommendation to buy or sell any security, strategy, or product. It should not be assumed that this is a forecast of future events or that any security transactions, holding, or sector discussed where or will be profitable or that the investment recommendations or decisions we make in the future will be profitable. Past performance is not indicative of future results.

We look forward to learning about your financial goals.