The Fixed Income Water is Getting Warmer

The fixed income water is getting warmer

Given year-to-date fixed income returns, one would be forgiven if they never wanted to own the asset class again. Such a view, however, could prove costly as, for the first time in a year, areas of the market are starting to look attractive. We believe that through tactical management and a creative and active approach, positive returns are possible. Below we highlight some examples in the fixed income universe that we are adding to or watching closely just as investors give up and flee the asset class.

Remember: returns are greatest where capital is scarce.

Rates fall when growth declines

In our experience, markets tend to under/overshoot fair value models. Case in point: investors grossly overpriced Treasuries throughout the previous year and a half, resulting in yields that were way too low. Today, however, investors have moved closer to fair value, and by some metrics, are underpricing Treasuries relative to our estimates. Given RBA’s fortunate position of being very underweight duration, and because of the move higher in yields, we increased interest rate risk while remaining underweight. It is becoming increasingly clear that the only path for the Federal Reserve is to tame inflation by bringing down demand. And growth, not inflation, is the biggest driver of longer-dated bond yields. Note the below table that shows the 10-year Treasury yield can reach a cyclical peak even with very elevated levels of inflation.

The Treasury math is getting interesting Although we doubt the 10-yr yields have reached their apex for this cycle, we are probably closer today than at any time over the last 2 years. If one were to buy a 10-yr Treasury note today, yields would have to increase to 4.3% over the next 2 years before realizing a mark-to-market loss. Although this is possible, if we enter a recession between now and then, and yields fall to 1.5%, the returns stand to be 17-23%. Clearly the upside/downside has shifted, creating an opportunity for us that we have not seen in some time.