Fixed Income Q3 2022

As the Fed pushes up interest rates and other central banks around the world follow, yields on fixed income continue to climb. This is welcome news for savers, as returns on cash and short maturity bonds are up significantly this year. However, the speed of the adjustment in market yields has resulted in a painful price correction for those already invested in bonds and bond funds. With bond coupons so low before the rate hiking cycle began, there is less coupon income to cushion the price adjustment. While bond prices often move in the opposite direction of stocks, they have moved in tandem this year, adding to the challenging market environment. Eventually though, the Fed will stop raising rates and this action may lead to a reversal in price declines. The U.S. Treasury yield curve is slightly inverted, meaning longer maturity bonds offer less yield than short maturity bonds. The yield curve’s inverted shape implies that investors do not think short rates will rise much above 4% before the Fed pauses and begins cutting rates. We agree with this view, which is one reason we have been active in buying slightly longer maturity bonds that offer attractive yields over an intermediate (2-5 year) time horizon.

Since August, volatility in bond market prices has risen significantly. The U.S. dollar rose sharply at the end of September, as demand for higher yielding dollar-denominated assets spiked. Other major currencies have weakened versus the dollar, adding to the volatility. The Bank of England
intervened in the Gilts and Foreign Exchange Market to support a sliding British Pound in late September. These big price movements in currencies and fixed income markets are likely to persist in the coming months. If they worsen, the Fed may need to take further action by either rethinking its forward guidance on interest rates or using its balance sheet to provide liquidity for investors buying dollar denominated government bonds. Our past strategy of investing in high quality, short duration bonds has paid off as these bonds have declined modestly, and much less than broader benchmarks.

We are finally in an environment where maturing bonds can be re-invested at higher interest rates. Along with cash balances earning ~3%, estimated portfolio income is on the rise, a welcome turn for our clients.

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