In October, with the added uncertainty of the future path of the federal funds rate—combined with the residual impact of the UK’s fiscal faux pas—the markets reached the yearly 2022 high of 4.35%. It has been CIO’s recommendation to incrementally add interest rate risk, with the expectation of below-trend growth in 2023. The heightened interest rate volatility led to a more prudent risk-adjusted strategy of adding interest rate risk within our fixed income portfolio, via our preference for higher-quality sectors such as agency MBS and investment grade (IG) corporate bonds versus the higher credit embedded high yield (HY) and senior loan sectors.
At the end of October, both IG corporates and agency MBS continued their worst-performing year on record, retuning –21% and –15%, respectively. On 20 October, CIO added IG corporates as an up-in-quality allocation versus senior loans and HY. Given senior loans’ floating-rate nature, the allocation resulted in an extension of interest rate risk out to 7.5 years. Since the end of October, the bid is back in fixed income as the two main drivers of return—interest rate risk and risk premiums—have both resulted in substantial positive return contributions.
Although we maintain our least preferred on senior loans given the maturing credit cycle—combined with the lagged impact of Fed rate hikes leading to potentially below-trend growth in 2023 and rising default rates—we are adjusting our allocation along the IG maturity spectrum. Since the 20 October inception, the least preferred on loans versus most preferred on 7–10-year IG has returned over 7% as of the 7 December close.
With the 10-year yield rallying 80 basis points since October, combined with the deepening inversion of the yield curve, we are shifting the longer maturity allocation within IG in favor of the short-end of the curve. The resulting allocation—least preferred on loans versus short-end IG—will remove a substantial part of the interest rate risk, and we will wait to reset at higher yield levels as we reach 4% on the 10-year yield in 1Q23.
While we await the next inflation report and the Fed decision next week, our range for the 10-year yield is 3.25–4% through 1Q23.Given the inversion of the yield curve, shifting to short-end IG from the 7–10-year area is essentially yield neutral. Although interest rates will remain volatile, the inversion of the yield curve is likely to continue over the next several months until the Fed ceases from its current path of hiking.
Main contributors - Leslie Falconio, Barry McAlinden
Content is a product of the Chief Investment Office (CIO).
Original report - Fixed Income: The fourth-quarter effect, 9 December 2022.
