There's more than one way to generate alpha
Rate strategies lead the way for bonds in challenging first quarter.
With tax revenues declining much less than feared from the Covid recession, economic recovery in full bloom and a flood of cash from the latest fiscal stimulus bill on its way, the credit outlook across most municipal sectors has shifted from negative to stable or positive. An accelerating vaccine rollout is supporting outperformance of mid- and low-quality muni credits that stand to benefit from a hopeful return to normal and unleashing of pent-up demand as America gradually reopens. Layered over this are $350 billion flowing directly to state & local governments and an additional $300 billion flowing directly or indirectly to other municipal sectors such as school districts, higher education and hospitals, thanks to passage of the $1.9 trillion American Rescue Plan (ARP) by a simple Democratic party line majority vote. More huge sums seem likely as the Biden administration seeks to push through a broadly defined $2.3 trillion infrastructure package that, among its many components, includes hundreds of billions for roads, bridges, transit and other items that typically come to mind when we hear the word “infrastructure.” The White House says it is hoping for bipartisan support, but the Senate parliamentarian has again cleared the way for a simple majority vote through the budget reconciliation process, a tack Dems took with ARP. Against this constructive backdrop, munis continue to experience positive flows, partially related to anticipated tax increases (the infrastructure plan proposes tax increases on corporations and wealthier households) and to limited supply in the primary and secondary market, which is causing new deals to be heavily oversubscribed and credit spreads to narrow within the muni market.—R.J. Gallo
Making money on bonds when yields are rising has its challenges. But yields’ inverse relationship with prices is just one factor in determining bond returns. By acting to capitalize on rate trends and the differential between shorter- and longer-term rates, bond portfolios can generate positive relative returns and even positive absolute returns during periods of rising rates. Depending on why rates are rising, certain sectors of the bond market can benefit from rising rates, too.
The above explains why Federated Hermes uses four independent fixed-income committees to recommend duration, yield curve, sector allocation and currency positioning across our fixed-income strategies. (Security selection is left to each sector group within each strategy.) Put simply, there is more than one way to generate alpha. Indeed, relying on this disciplined process to adjust portfolios to macro conditions, Federated Hermes fixed-income strategies generated positive absolute and relative performance over the past 12 months’ up-and-down Covid environment of declining and rising rates. Relative to benchmarks, our process resulted in more positive returns in 2020’s bond friendly market, and less negative returns in the past quarter’s rising-rate bond bearish environment.
Staying short duration
Clearly, the worst quarter in 40 years for Treasury bonds (as measured by the performance of the U.S. Treasury Index) left investors shaken in the year’s first three months. But two somewhat conflicting things to note. Yields still are historically low—most real rates remain negative—but the sell-off has restored some value. Three months ago, a 5-to-10 basis-point jump could have wiped out an entire year’s income. That’s not the case today. Still, staying short on duration makes sense as the rate bias remains up. A strengthening recovery, rising inflation and a stimulus-fed need for massive issuance—$5 trillion and counting—all point to higher rates. However, the worst performance impact from higher rate levels is probably behind us.
‘Nuancing’ yield curve & currency calls
After a significant run-up in long yields, we think the longer end of the curve has cheapened so much that the best steepener opportunities may lie along the shorter 2-/10-year segment of the yield curve. We’re nuancing our currency and credit calls, too. While rising new debt and issuance typically argue for dollar weakness, all the stimulus and widespread vaccinations have the U.S. leading the global reflation trade, creating significant yield differentials relative to other countries that make it too hard for the carry trade to pass up. So, our dollar view is somewhat mixed.
Lower quality credits OK
While investment-grade may benefit somewhat—that trade is stretched—high-yield and emerging-market securities have more room to run from stronger U.S. growth. The best opportunities may come from specialized segments of the credit market strongly linked to global economic growth, such as bank loans, trade finance and fixed-income strategies with equity exposure.
The Fed keeps signaling it’s on the sidelines as long yields rise, and hopes stronger demand from aging boomers may prove a countervailing force are questionable—they’re nearing the tail end of their distribution curve. As for the younger generation, forget about it. If the Reddit and Robinhood trading craze is any indication, they’re not even thinking about thinking about bonds.
In short, it does seem cyclical and structural forces represent headwinds for bonds. However, at the end of the day, bonds really serve more as a risk diversifier than a returns producer—not that returns are an afterthought. As the past year has shown, even in challenging markets, there always are more than one way to generate alpha.