A few months ago, in my most recent article for Rethinking65, I discussed the relative value available in callable government sponsored enterprise (GSE) debt. At that time, debt from some of these private entities created by Congress provided yields that equaled or exceeded those on many investment-grade bonds. The article proved prescient (or perhaps just lucky), as it was published shortly before the banking turmoil caused by the failures of Silicon Valley Bank, Signature Bank and First Republic.
We continue to find good value in callable GSEs. However, as the markets digest fallout from three of the four largest bank failures in U.S. history, caution has become the mantra.
Risk management
We have recently seen yields on some regional bank bonds spike to double digits, even as yields on the money center banks hover in the 5% to 6% range. Interestingly, this spike has happened among banks that are still rated investment grade (BBB- or higher) by the major ratings agencies. The bond market is concerned about contagion and is demanding higher yields to compensate for the higher perceived risk.
Be wary of the temptation to dive in. While these spreads may be tempting, remember that your clients are likely allocating their risk to their stock holdings. Fixed income should be the “safer” component in their holdings. Think carefully before doubling down by taking significant risks in their bond portfolio, too.
Fed roundup
At its meeting on May 3, the Federal Open Market Committee announced it would raise its benchmark Fed Funds rate by 25 basis points (0.25%) to a range of 5.00% – 5.25%.
In its issued statement, the committee commented, “Economic activity expanded at a modest pace in the first quarter. Job gains have been robust in recent months, and the unemployment rate has remained low. Inflation remains elevated … The U.S. banking system is sound and resilient. Tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring and inflation … The Committee remains highly attentive to inflation risks … The Committee is strongly committed to returning inflation to its 2 percent objective.” (For emphasis, I have bolded what I felt were the Fed’s most important comments.)
Talking heads and traders everywhere parsed the FOMC’s release for clues that it was finished raising interest rates. While many market participants expect the Fed to cease raising rates and eventually pivot to a series of cuts later this year, we see that as unlikely.
Inflation persists
First, the Fed has cooled inflation with more than 500 bps of tightening in this cycle. Admittedly, we are likely closer to the end of the tightening cycle than the beginning. That said, inflation is still persistent and at this point controlling it is job No. 1 for the Fed after being late to the party at the beginning of 2021.
The April CPI report showed a 0.4% month-over-month increase in the headline number, and a 0.4% MOM increase in the core (excluding food and energy). On a year-over-year basis, headline inflation rose 4.9% in April, down very slightly from 5.0% in March. Meanwhile, the core inflation number rose 5.5%, down from 5.6% in March. The CPI report was hailed by some as a strong signal that inflation is slowing.
‘Plenty of runway’
The yield curve remains significantly inverted, with one-month Treasurys near 5.5%, two-year Treasurys near 3.9%, and 10-year Treasurys near 3.4%. So, after 500 basis points of Fed tightening, long-term rates are up less than 200 basis points, and the 10-year bond is yielding less than 3.5%. In other words, 10-year Treasuries still have a real yield (after inflation) of -0.5%. The Fed still appears to have plenty of runway.
We do not anticipate a Fed pivot anytime soon. The Fed has acknowledged that it would not cut rates during 2023. When investing in the current environment, implementing a ladder or barbell portfolio may be beneficial. Currently, allocating to short-term T-bills offers both liquidity and yield, while providing a funding source to selectively move into longer-dated bonds that lock in these higher rates.
More attractive yields
As discussed, new-issue callable GSEs seem to offer the best risk/reward tradeoff in the current environment. That’s especially when they’re yielding around 6%, or about +250 basic points above the 10-year Treasury. However, most new issues (across GSE, corporate and municipal bonds) are coming to market with call features — so, be careful when bonds are trading above par and monitor your portfolios for redemptions.
After 500 bps of tightening, the Fed Funds rate has returned to about average. Meanwhile, 10-year Treasuries are still below their long-term average yield of about 5%. Simply put, it appears we are entering an interest-rate environment that is a return to normal, versus the historically low-rate environment that we have experienced in the relatively recent past. As a result, many of our clients are seeing more attractive yields on their bond portfolios for the first time in a long while.
How the debt ceiling factors in
In what appears to have become an increasingly frequent and heated event, politicians are using the debt ceiling as leverage to achieve other policy goals. Republicans and Democrats must compromise and pass legislation to raise the debt ceiling so the U.S. Government can continue to meet its financial obligations. This process, which has morphed into a political hot potato, has occurred 20 times since 2002. However, the political brinkmanship has escalated in the last few years, and has become quite tiresome for many. Unfortunately, headlines about the U.S. Government defaulting on its debt (currently $31 trillion) makes for some great “click-bait,” and can be panic-inducing among clients and the general public.
Historically, stock market volatility has risen heading into debt ceiling discussions, and then subsides once Congress votes to raise or suspend the debt ceiling. On the bond side, The U.S. Treasury department often reduces issuance of new securities as the ceiling approaches. This lower supply of bonds often causes prices to rise and yields to fall. Both of these trends reverse and normalize once the new level is approved. While it may take until the 11th hour, we expect a compromise to raise the debt ceiling.
What if the unthinkable happens?
If principal is not paid on a scheduled Treasury maturity date, the maturity will be extended by one business day for purposes of continued trading. The Treasury will instruct the Fed each evening whether the maturity needs to extend another business day. Missed coupon payments are not transferrable.
If the bond trades post maturity date, the eventual return of principal will be paid to the holder of record on the final extended maturity date.
If a coupon payment is delayed, the holder of record the day before the coupon payment was scheduled will receive the future payment. No partial payments will be made. Bonds will continue to trade as if the coupon had been paid. No additional interest will accrue on the delayed coupon payment.
Any compensation for delayed payments must be approved by explicit legislation by Congress. The Treasury would need to determine how this compensation would be paid.
Obviously, any temporary default will undermine the confidence in the Treasury and the U.S. Dollar as a reserve currency. In this event, we would expect to see investors, especially foreign ones, demand higher returns to compensate for risk of another default. For this reason, we do not see a default as a likely scenario, as cooler heads should prevail.
Christopher Baccella, CFA, is a wealth advisor with Mariner Wealth Advisors. He develops personalized wealth management solutions for clients to help them achieve their goals and to grow and protect their wealth, and provides investment management services to institutional clients. Chris has over 16 years of experience in the wealth management industry. He can be reached at chris.baccella@marinerwealthadvisors.com. Click here for disclosures.
