Published on 10 November 2022.
Opportunities within the cluster
The recent rise in interest rates and heightened volatility affected all sectors within fixed income in 2022. The clustering of returns regardless of income or credit quality was unusual, particularly given the significant correction within the equity market. We show the historical annualized return and volatility for over a one- and five-year period ending on 3 November. As shown, fixed income investors lost as much in higher credit embedded HY as they did in AAA rated TIPS, US Treasury, or agency MBS over the past year. Not only was there a cluster of similar returns, but volatility was also relatively clustered for most sectors. As financial conditions forcefully tightened, the differentiation one might anticipate from risk-adjusted returns was nonexistent over the past year, with the exception of taxable municipals and preferred securities.
The five-year risk adjusted return, which is more representative of the “norm,” shows a much wider dispersion. And as we head into 2023, with interest rates at or near 2007 levels, a repeat of the magnitude of rate rises seen in 2022 is highly unlikely. The market will focus on the lagged effect of Fed rate hikes on the real economy, and we favor a more defensive posture that balances inflation and elevated recession risk. And as the one-year risk-adjusted returns dictated in 2022, the value heading into 2023 lies within higher-quality sectors, which faced greater performance headwinds from rising rates and high volatility.
The end is near…
While the November Fed meeting confirmed that a shift in the direction of rate hikes will not be forthcoming anytime in 2022, the market is now pricing in a terminal rate between 5% and 5.25%, alongside a 50bps rate hike in December and February followed by an additional 25bps in March. Although this is what the market anticipates, sentiment may shift depending on the data over the next several months. And while we anticipate the higher-for-longer mantra to remain intact, rate-sensitive sectors such as the housing market have already begun to feel the impact of a slowing economy—mortgage rates have pushed past 7%—a 20-year high—and multiple housing indicators are showing signs of slowing. New home sales have been positive for just two months in 2022; existing home sales have been negative for seven consecutive months; mortgage applications have been positive for just three weeks since July; and the Case-Shiller National Composite Index rose 13% in August, down from 15.6% in July, the largest deceleration on record.
Rising interest rates are also starting to weigh on the consumer. The Fed’s survey on consumer credit conditions highlighted the spike in consumer credit, which has followed the decline in the personal savings rate. Households had been depleting their savings to adjust to the rising cost of living and are now forced to borrow at higher rates. Although we view the shape of the yield curve as a coincident indicator, the Fed’s preferred 3-month/10-year spread inverted for the first time this year on a closing basis, while the 2-year/10-year has remained inverted for nine months and recently reached –60bps, the largest inversion since 1981.
Finally, the Conference Board Leading Economic Index has declined for seven consecutive months. There has never been a period when four straight monthly declines were not accompanied by a recession. We acknowledge the pandemic-era paradigm supports the “this time it’s different” argument; however, seven consecutive declines should not go unnoticed and is indicative of the potential slowdown that lies ahead. Although we do not expect the Fed to shift policy direction soon, lowering the magnitude of rate hikes is a signal that the end may be near for overly hawkish rhetoric as the market prices in a higher terminal rate near the end of 1Q23.
As we have shown, a pause will push 10-year yields lower, and we expect a slowing economy ahead. Interest rate exposure will shift from a headwind to a tailwind in 2023, and although we are respectful of the fourth-quarter malaise, we are adding incremental interest rate risk within our fixed income portfolio allocations.
While the Fed is specifically trying to weaken the economy to reduce inflationary pressures, investors have yet to receive the benefit of lower yields and higher prices. However, one benefit is that the long-term driver of fixed income total returns—yield—has been burgeoning in full force. As discussed, the coupon or income earned entering 2022 was no match for a rising-rate, widening-spread scenario. In today’s environment, however, the landscape has changed. Investors are now able to earn over 6% for higher-quality sectors. This underlying cushion is a strong safeguard if inflation remains elevated, the labor market remains tight, and the Fed underestimates the level of restrictiveness needed to tone down inflation.
We run the breakeven yields per unit of duration for various fixed income sectors. Put another way, how much can interest rates rise before wiping out a year’s worth of income? The amount of embedded cushion within fixed income towers over previous years (for most sectors), including the 2018 cycle. Not only do investors have an additional benefit not provided at the end of 2021, but they are also able to allocate to higher-quality sectors such as agency MBS and investment grade (IG) corporates as a way to earn income while increasing their performance shield should the economy slow sharply. The days of “quest for yield” are behind us, and fixed income is well positioned entering 2023.
We believe both agency MBS and IG corporates are cheap, but agency MBS remains cheap relative to IG corporates. We discuss in greater detail in the section devoted to mortgage-backed securities. Rising interest rates have already started to affect the housing market, and with a mortgage rate that is 300bps over the 10- year Treasury— which has only been witnessed twice over the last 35 years—agency MBS has cheapened well ahead of other sectors. The sector’s higher yield in relation to its current coupon, lower dollar price, and AAA rating has set the stage for crossovers and up-in-quality buyers in 2023.
For more see the full report Fixed Income Strategist: The end is near 10 November 2022.
Main contributor: Leslie Falconio
This content is a product of the UBS Chief Investment Office.