As the Federal Reserve prepares for its meeting this week, bond investors are anticipating a possible recession and preparing for an end of the tightening cycle. They have turned to the safety of U.S. Treasuries and sold risky exposures in investment grade and high yield credit. This defensive stance has been further reinforced by the collapse of Silicon Valley Bank and Signature Bank in March and the current turmoil at First Republic Bank.
Investors are expecting the Fed to raise interest rates by 25 basis points to a range of 5.0%-5.25%, followed by a possible pause and rate cut in the fall. However, the debt ceiling saga has complicated the thinking on that scenario. Since last March, the Fed has raised interest rates by 500 bps in one of the most aggressive tightening cycles over a similar time span since the late 1970s.
Chip Hughey, Managing Director, Fixed Income, at Truist Advisory Services, believes that tight monetary policy combined with tighter lending conditions in the banking system will result in growth continuing to slow as we move through 2023. As a result, fund managers have either stayed neutral on their risk stance, stuck to Treasuries and high-quality investment grade corporate bonds, or extended duration in their portfolios.
Lon Erickson, Managing Director and Portfolio Manager at Thornburg Investment Management, suggests that any recession and rate cuts should reverberate throughout the curve into the five-year, ten-year, and thirty-year part. Therefore, investors should have more duration on because that means they will get more bang for their buck for that interest rate move. In the credit sector, Thornburg has gravitated toward businesses such as health care and utilities, viewed as resilient in a downturn.
Data shows that U.S. government bond funds secured $2.22 billion worth of inflows in the week ended April 26, compared with net selling of $2.14 billion in the previous week. Treasury ETFs also saw inflows during the week totaling $634 million. In terms of price action, U.S. five-year yields dropped 67 bps since March, suggesting increased demand from investors, while U.S. ten-year yields dropped 47 bps.
Chris Diaz, Portfolio Manager and Co-Head of Global Taxable Fixed Income at Brown Advisory, said long duration in the firm's bond portfolio is concentrated in the two- to the seven-year part of the curve, with the firm holding low levels of credit risk. They are significantly underweight investment grade corporate bonds and have no high yield.
However, some investors have opted to stay "neutral duration" on their strategies, citing outsized moves in Treasuries that saw a big rally, combined with the uncertainty surrounding the debt ceiling. Todd Thompson, Managing Director and Portfolio Co-Manager at Reams Asset Management, believes that the market has already raced ahead, and investors do not want to lean against that too much because of the debt ceiling debate sometime in the summer.
In conclusion, the bond market is currently navigating a nerve-wracking environment as it prepares for a possible recession and the end of the Federal Reserve's tightening cycle. Bond investors have turned to the safety of U.S. Treasuries and sold risky exposures in investment grade and high yield credit. While some have extended duration in their portfolios, others have opted to stay neutral, citing outsized moves in Treasuries and the uncertainty surrounding the debt ceiling.
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