Fixed Income Outlook: If it's not broke (yet), why fix it?

10-17-2017

At the risk of sounding too complacent as we enter the final three months of the year, the quarter may have changed but the fixed-income story remains the same: modestly rising rates and tightening corporate credit spreads. Moderate economic growth, a still-accommodative Fed and a business-friendly Washington, warts and all, continue to provide a constructive foundation for spread product. If this sounds familiar, it’s because this pretty much has been the case all year, which is why we have stuck with an overweight to high-yield and investment-grade corporate bonds in our models. From our point of view, if it’s not broke, why fix it? Once again, high-yield and investment-grade credit have been the biggest generators of alpha across Federated’s fixed-income universe so far this year.

To wit: year-to-date through Oct. 4, the high-yield market as measured by the Bloomberg Barclays U.S. Corporate High Yield Index has returned 7.12%, and the investment-grade market as measured by the Bloomberg Barclays U.S. Credit Index has returned 5.22% compared to the Treasury Index return of 2.26%. Our active strategies in those two sectors have done even better.

Our duration call—a modest short—has had less opportunity to add value, as rates experienced net movements of less than 5 basis points each of the last two quarters. Amid a series of legislative stumbles, the biggest being Congress’ inability to repeal and replace the Affordable Care Act, the 10-year Treasury yield trended down in the first quarter, settled in a relatively narrow range in Q2 and much of Q3, then jumped 21 basis points in September to close the quarter at 2.33%. We would not be surprised to see it reach 2.50% by year-end.

Valuations stretched
To be sure, market valuations are getting a little stretched. Credit spreads—the gap between yields on corporate bonds and comparable maturity Treasuries—already are below historical medians. While past cycles suggest spreads can narrow further and remain at tight levels for prolonged periods, there will come a time when we are going to have to decide whether to cash in some of our chips and moderate if not lift entirely our credit overweight. We don’t think we’re there yet. As I’ve said before, it’s hard to be short on risk when you have so many positive underlying economic fundamentals, ranging from job growth, manufacturing’s rebound and robust corporate earnings to rising confidence, increasing incomes, and solid corporate and household balance sheets.

The wild card, to some extent, is what comes next out of Washington. At some point, the market is going to want to see what President Trump and the Republican Congress actually can deliver. From the market’s perspective, it helps to have a GOP White House and Capitol Hill with a mindset aligned with business principles. There has, for example, been progress on the deregulation front. But the biggest unknown is whether tax reform can move from promise to reality and, if it does, what will it look like. As investors are wont to do, they have been buying the rumor—and we’re still in rumor stage. But will the news on tax reform, if it comes, be strong enough that the market won’t sell the news? That’s not to suggest fixed-income would prefer “shock and awe,” as President Trump has promised. If anything, the bond market would probably be happier with a tax package that exhibits some fiscal restraint.

Remember the bond vigilantes?
Think about it. Unfunded tax cuts, i.e., reductions that are not funded by revenue offsets elsewhere, can be a big problem for bonds. Remember the bond vigilantes? Their massive sell-off in the mid-1990s hurt a lot of portfolios but also helped bring a sense of fiscal discipline to all the checks that were being written by Washington early in the Clinton years. Some may argue these vigilantes drove policy changes that actually saw the country run a surplus for a few years. I wouldn’t be surprised if the bond vigilantes were to re-emerge if the White House and Congress put forth a plan that relies on gimmickry to make tax cuts work. Sure, some level of dynamic scoring—inflated revenue estimates in line with projected growth arising from tax cuts—is to be expected. But as Sen. Bob Corker, the Tennessee Republican and deficit hawk who doesn’t plan to run for re-election has made clear, there are limits to its use. Republican mavericks such as Corker, Sen. John McCain and Maine Sen. Susan Collins, all of whom have broken with Trump on key votes, may hold the key to whether modest tax reform gets done.

Whatever happens is really more an issue for 2018 than for the next few months. On a nearer-term basis, we can identify some potential market movers in both directions. On the side of lower rates, risks include further escalation of the Catalonia-Spain independence movement; worsening tensions with North Korea; surprises arising out of the Russian election-influence investigation; or the introduction of protectionist legislation that has a plausible path to passage. The other side includes the reemergence of the Phillips Curve—a supposed inverse relationship between the level of unemployment and the rate of inflation—as witnessed by the wage numbers in the latest employment report, the possibility of a more hawkish Fed chair (Kevin Warsh is still seen as one of the front-runners) and seasonal issues, including possible year-end selling by fixed-income managers such as us who have may wish to lock in gains and call it a good year. Any of these on either side could cause market volatility. But for now, the message remains: Stay the course.