What Bond Investors Should Expect During the Balance of 2022

Audio Description

After a tough start in 2022 due to rising rates, what's next for bond fundamentals and performance? Bernstein Muni Portfolio Manager Daryl Clements discusses his outlook and whether there's any opportunity in the near term.



This transcript has been generated by an AI tool. Please excuse any typos.

00:04 - 00:41

Hi, everybody, and welcome to The Pulse, where we cover trends in the economy, markets and asset allocation for long term investors. I'm Matt Palazzolo, senior investment strategist at Bernstein and head of our Investment Insights Team. The equity markets have been particularly volatile in recent months, and typically in periods of market volatility, bonds are a safe haven. And yet so far in 2022, even bonds have suffered, as investors have feared, a new regime of higher inflation and higher interest rates. And so to discuss the happenings in the bond market and in particular municipal bonds, I'm joined by our muni bond portfolio manager, Daryl Clements. So, Daryl, welcome to the show.

00:42 - 00:43

Thanks for having me, Matt. Appreciate it.

00:44 - 01:08

So this year has been one of the worst returning years for muni bonds in several decades. And I think at one point, muni bonds were down double digits, even for high quality bonds, which is how we allocate for our clients and their risk mitigating portion of their portfolio. So let's just level set everybody. How did we get here? How do we get to a point where bonds are down as much as they are in 2022?

01:08 - 02:03

You know, that's interesting that you're right. It's been a few decades. You'd have to go back to 1980, 1981 to find a start of the year that's been as rough as this one. But to better understand where we are, we do have to go back a little bit. So if we go back to last year, last year, municipal bonds had a good year relative to treasuries. For example, Treasuries had negative performance. Municipal bonds have positive performance. Now, the reason I bring treasuries into it, because there's a relationship there and municipals became expensive relative to Treasuries to start the year. And no matter what land you look through, Matt, whether it's a muni treasury ratio after tax spread, whatever your preferred measure is, municipal bonds were expensive, meaning their yields were too low relative to Treasury yields and the municipal market pushed back a little bit. And Jan and I'll break it down in two stages, if you will.

02:03 - 02:30

So Jan, there was that pushback where investors said we're not buying bonds at these shows and yields rose in January in anticipation of future Federal Reserve moves. So, for example, a ten year treasury was up 27 basis points. A ten year triple-A municipal bond doubled that. And so what that did very quickly was moved bond municipal bonds from expensive to fair value.

02:30 - 03:03

But it didn't stop there and stage to say February, March, April into May, you had outflows in the municipal market. And when you have outflows, when investors are nervous and they're selling their bonds, what does a manager have to do? They need to sell to meet that redemption. So there was a lot of secondary market supply hitting the market. And when demand was trailing off and you have a lot of supply on the secondary market, what does that do? That drives yields higher.

03:03 - 03:34

So municipal bonds went from expensive to start the year to fair value in January to cheap as we ran through, let's say May as we got into mid-May, they became very, very cheap relative to treasuries, meaning municipal yields were actually higher than Treasury yields. So that's kind of how we got here, where municipal bonds have performed poorly relative to treasuries and even corporate bonds in this environment.

03:34 - 03:58

So Daryl you're talking about and that was great. You're talking about flows and sentiment and relative valuations for municipal bonds compared to treasuries. How, if at all, do the fundamentals for municipal bonds play and meaning? Were there concerns in investors minds that the fundamentals were breaking down? And did that cause any of the outflows?

03:58 - 04:39

No, it wasn't. That is not a fundamental concern. Municipal credit fundamentals are as strong as they have been since you'd have to go back pre financial crisis to find a period where municipalities states were in as strong of a credit position. So that wasn't the concern. The concern was all around rates. And where is the Fed going? We all know yields are going higher. And by the way, if you're a bond investor, you want yields to rise. That is the engine of a bond. You just don't want them to rise as quickly as they have. It takes it takes a while for a bond portfolio to digest a large move in yields. But it wasn't credit related. It was rates related.

04:39 - 04:52

That's interesting point, that municipals are in as good of a shape as they are. I think that's a point that's missed by many investors, particularly when you see and feel such a sell off that has occurred. Why is that? Why are municipals in such good shape?

04:53 - 05:22

Two reasons. The municipalities were expecting the worst back in 2020 when the economy began to shut down. They were budgeting for a. A deep recession. A deep recession. That didn't happen. It was a shallow recession. And it was really focused in that leisure and hospitality sector. So most of us were able to go home and work, continue to get paid, continue to pay our taxes. So they budgeted for the worst and the worst didn't happen. So that was part of it.

05:22 - 06:14

The second variable there was we had have a very, very generous federal government in terms of the stimulus money that were provided to states and municipalities. And to give you an example, at one point the state of California was running a $75 billion budget surplus. And then the last stimulus money that they received, they received another 25 billion on top of that. So they're in great shape. And even those states that you would say like in state of Illinois or a state of New Jersey, that, to put it kindly, are well, maybe not so kind of like the poster child children of how not to run a state maybe. But nevertheless, they they've been upgraded recently. That's how we got here. So from a fundamental perspective that that is when I'm listing concerns in a bond portfolio that is coming pretty far down the list.

06:14 - 06:25

Just to summarize, the sell off has occurred. It's not fundamentally driven. Municipalities are in very good shape. It's more interest rates and valuations relative to treasuries.

06:25 - 06:41

Now, if we're focusing on the interest rate move, let's now look forward as opposed to back. I know you and your team coordinate very closely with the economics department. What are you all collectively thinking? Is the direction of interest rates going.

06:41 - 07:22

Forward where we are today? So if you think about put it in Treasury terms, ten year Treasury and we'll talk short rates as well. Ten year Treasury is roughly about a 3%. As we as we talk today has been up a little bit higher with the lower, but let's call it 3%. Our expectation for this year was a ten year Treasury added to 75 and next year at a three and a quarter, we still maintain that. Think about on the short end though before we get how that how we get to that that three and a quarter. Think about what the Fed is trying to do on the short end. They're increasing the Fed funds rate. We think the Fed would like to get to three and a quarter, three and a half if they can get there. That's kind of neutral in our.

07:22 - 07:24

Mind on the Fed funds rate at the short end.

07:24 - 08:03

That's right. That's exactly right. So if we get to three and a quarter, three and a half over the next two years, let's say a year and a half, two years, the ten year Treasury would be hard pressed to push much higher than that, because what the Fed's trying to do conceptually is to slow the economy and tame inflation. And long yields are a reflection of economic activity so that slowing inflation is slowing as well and declining. Then the ten year treasury or longer yields will not push much higher than three and a quarter, three and a half, let's say. So we're confident in that the market will be volatile.

08:04 - 08:26

I would tell you the Treasury market is a bit shallow in terms of buyers because the top three buyers of treasuries are not buying a hell of a lot of treasuries right now. Right. The Fed, the Bank of Japan and just U.S. banks in general. So if there's more volatility in the treasury market because of that, but nevertheless, we think it settles in and around that to 75 to 3 and a quarter over the next year or so.

08:26 - 08:44

Okay. And speaking of buyers, let's now move from the Treasury market over to the municipal market. You and your team often talk about the technicals, supply and demand within the muni market. How does that tend to influence returns and what are you seeing for the technicals over the next handful of months?

08:44 - 09:42

Well, right now, throughout this year, the technicals have been poor. Right. There's been outflows. There's been roughly 60 billion in outflows in the municipal market. We are bucking that trend. We have inflows. So we're in somewhat of an enviable position here where we have cash coming in when deals arise. So that puts us, as I said, in an enviable position. But the technicals are turning and it's something there's a seasonality mat to the municipal market and you could set your watch to this next what we're going through right now, and that is every June, July and August, two things happen. There is a woeful, woeful lack of supply in the municipal market. And quite frankly, it's simple. People go on occasion, bankers go on vacation. They're not issuing a lot of bonds during June, July and August. But what that is met with is a significant amount of reinvestment. That reinvestment comes in the form of coupon payments, bonds maturing and bonds being called away.

09:42 - 10:02

And those three months are that's a significant period of time for reinvestment that is going to total roughly $62 billion in June, July and August, meaning there's going to be $62 billion more in cash or more cash to be reinvested. Then there are bonds to buy.

10:02 - 10:31

So all things being equal, I know they really are, but all things being equal, that is a tailwind to the municipal market. So the question is, is that tailwind enough to push through the headwinds of rates? And we think it is and you've already begun to see that influence. So Bonds, as you pointed out, have rallied more recently and you can market that rally began on May 19, a little sooner than I would have anticipated, Matt.

10:31 - 11:17

I thought it was going to rally in early June, but I think it rallied a little sooner than that because managers got a little ahead of themselves, meaning they raised too much cash in anticipation of outflows. The outflows have been declining, they're stemming. And now managers saw themselves with a lot of cash. The outflows were slowing and they were seeing that cash coming in beginning June one. So they started to put that cash to work in mid-May. So I think as we go through the remaining part of June through August, I think bonds will stabilize here. You'll have your up days on your down days. It's not linear, but I think at the end of August, values will be higher than than where they are today.

11:17 - 11:22

That's interesting. I didn't completely appreciate the seasonality of the municipal bond market.

11:22 - 11:55

But moving on, Daryl, as prices have fallen, whether it's in the stock market or the bond market, there's always opportunity. And and so the responsibility is on folks like you to determine how to take advantage of that opportunity, at least in the equity market. One of the ways that portfolio managers take advantage of opportunity when there's a sell off is to harvest losses. So you and your portfolio management team are active managers within bonds. It's not a ladder, it's not static. You are actively managing as part of that active management, harvesting losses when you get into periods like this.

11:55 - 12:26

Absolutely. And that's counterintuitive to a lot of investors, especially bond investors, because the initial thought process of a bond investor is, well, if I hold the bond to its maturity, I'll just get back what I paid. Right. And in certain instances that's true. However, think of the math behind taking a loss in a bond. What's the reason that your bond has a capital loss? Most likely interest rates have risen as we've seen in this environment. So rates are higher. The bond has lost value.

12:26 - 13:07

Now, it's a very simple decision tree from here, Matt, there's only there's only two branches on this rate. You can hold that original bond to its maturity or you can sell that bond, take that loss that is real, that is measurable, that is an asset to a client where you can offset a gain somewhere else, take the proceeds, reinvest now in a bond that has a higher yield than the one you are selling. And if the math works, meaning that by taking that loss, harvesting below us offset again and reinvesting at a higher yield. If you can come out with a higher after tax return versus holding that original bond, you make the trade.

13:07 - 13:49

So in this environment, we want to be active in what we're doing that we've changed a little bit. We've become utilizing technology to a larger degree and utilizing our optimizer, a portfolio management tool. And that optimizer is scanning all of our portfolios on a daily basis, looking for those losses, calculating what the cost is, the market cost of trading that bond, and what's out there in the market to buy, to replace. And we are systematically harvesting losses throughout the year. So far we have sold roughly $4 billion in bonds to harvest losses and there is more to come. We're trading every day to harvest to take that value or that asset get that that asset to our clients.

13:49 - 14:12

I think that that usage of technology is fantastic to highlight. We usually think about the bond market as being, you know, excuse the term Daryl antiquated, right? People still call up right you desk to desk phone. You know, what bonds do you have for sale different than the equity market? But to be able to utilize technology, bring it into the 21st century, I think it's fantastic to the benefit of clients we're bumping up against our time.

14:12 - 14:38

So I just want to ask a couple more questions. Darrel, I'm going to be a little bit tough with this one. Play devil's advocate. Interest rates have come down for the last four decades, and that's been wonderful for bond investors. Rates come down, prices go up. But potentially we're in an environment where rates won't continue to fall. They may even go up for some period of time. Is it even a good time to own bonds if rates are going to be flat to higher?

14:38 - 15:16

That's a really good question. And not to sound listen, I'm a Bond guy, right? But I'm not so myopic in my thought process. Right. I don't do bonds as binary a binary decision. It's not your in, your out. So you're into maybe varying degrees depending on the environment. And in this environment, when I look at bonds or cheap, you have a starting yield today that is much higher. Lighter than where it was just six months ago. So you have much more protection in a portfolio against rising rates. So today is a much better entry point than it was on January one.

15:16 - 16:08

To give you an example, to break even on a dollar, a dollar invested today in an intermediate bond portfolio, you would need just to break even on that dollar where you're not earning anything on it. You not losing anything, you're just treading water. A year from now, that dollar still worth a dollar. The ten year Treasury would have to reach a little over 4%. In the next 12 months. And that's not our forecast, that's for sure. As we talked earlier. So when I look at it and say, well, bonds are we have a higher yields. They're cheap. You have the technical factors in your favor. You need to see a pretty sharp move in a ten year treasury just to break even on that dollar. So, yes, I would say it is a good time. But again, we want to be thoughtful about it. And there's a lot of uncertainty here. And I have been telling clients to dollar cost OC.

16:08 - 16:32

I think that's a great place to finish up. Daryl And we've covered a lot of ground over this period of time. We talked about the fundamentals. We talked about the causes for the sell off so far this year. And you essentially built out the case for municipal bonds today relative to not doing anything, potentially leaving in cash or elsewhere. So, Daryl, I want to thank you for joining us on the Pulse. And if look, if we have more volatility in the bond market, we're going to certainly have you back.

16:33 - 16:34

Thank you for having me, Matt. Appreciate it.

16:35 - 16:58

And thanks to all of you for listening. Municipal bonds may not get all of the attention in the financial press that they deserve, but it's an important cornerstone for most asset allocations. And as Daryl said, prices and fundamentals often diverge and those can create opportunities for investors. And as always, we'll continue to monitor the key trends and the risks in the economy and share them with you here on The Pulse.

16:58 - 17:17

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