SBH Investment Summit
Fourth Quarter 2023

Fixed Income Market Dynamics: Rising Yields, Opportunities, and Mitigating Risks in Today’s Market

Fixed income markets have faced challenges this year, as the Fed continued to raise interest rates to tame inflation. However, despite inflation moderating over the past year, interest rates have continued trending upward.

Jim Dadura, CFA, Director of Fixed Income, discusses current market dynamics and where SBH is finding opportunities as we head into 2024.

 

Key Takeaways

  • Even though inflation has come down over the past year, yields continue to rise, with real rates moving higher.
  • Over the last two years, the upward buying trend of U.S. Treasuries has reversed as both the Fed and large investors have reduced their holdings. This, along with continued issuance of Treasuries by the government, is contributing to higher rates.
  • We are finding the short-end of the maturity market particularly attractive as the relative yield advantage of money market funds has narrowed substantially, allowing investors to lock-in yields for longer in the short-maturity space while seeking to avoid reinvestment risk if rates fall.
  • High yield is another attractive area, with the higher quality end of the market looking particularly strong, with yields well over 8% and relatively little interest rate risk.

[Mark Rewey] Fixed income has remained a key discussion over the past year. While we have seen inflation reach a more controllable level, there is still room for it to decrease further. At the same time, rates continue trending upward. Jim, could you provide a backdrop of how the market reached this point?

[Jim Dadura] This time last year, inflation was over 7%; at the end of September 2023, inflation was down to 3.7%. At the same time, interest rates are trending higher. The reason why rates are going higher is that real interest rates are increasing. Real interest rates are the interest rates you receive after being compensated for inflation. Exhibit 1 shows the yield on the 10 Year Treasury. The top line is what we call the nominal rate or the total rate of interest an investor receives which stands at 4.92%.

The light shaded area represents inflation; looking at inflation-protected securities on a 10 year, the expected inflation is 2.47%. What is left over is what investors receive after adjusting for inflation which is called the real rate, currently at 2.45%. Positive real rates are not unusual as you can see on this chart. Prior to the Global Financial Crisis (GFC) in 2008, positive real yields were the norm. Real yields fell to negative levels post the GFC as the Fed purchased bonds under quantitative easing. This drove real yields down; they were negative as recently as April 2022.

Exhibit 1: The Total Rate of Interest Investors Receive on the 10 Year Treasury is at 4.92%

Source: Bloomberg as of 10/20/23. The real yield is calculated by subtracting the expected inflation rate (10 year TIPs breakeven inflation yield) from a bond’s nominal yield (10 year U.S. Treasury yield).

 

Now the Fed has reversed course. Exhibit 2 illustrates that the Fed is reducing its Treasury holdings as are large investors such as commercial banks and foreign investors. While these institutions are reducing their holdings, the U.S. Government has continued to issue more Treasuries, which need to be absorbed by the market. This is one of the main reasons we are seeing interest rates go higher driven by real interest rates.

Exhibit 2: Major Holders Have Reduced UST Holdings by $845 Billion Despite Continued Issuance

Source: Year to date change in UST supply and combined Fed/bank/foreign UST holdings. Data as of 6/30/23. Source: Bloomberg.

 

[Rewey] With that backdrop in mind, what opportunities do you see?

[Dadura] Rising real yields mean investors receive a positive return after inflation. The short end of the maturity spectrum looks especially attractive right now. In the last year, investors in money markets who wanted to lock in yields with longer maturities had to actually give up a significant amount of interest. As recently as May 2023, investors in money market funds who wanted to lock in a 2 year Treasury yield gave up over 1% of interest. Today, that difference has narrowed substantially with the 2 year yield at over 5%. Exhibit 3 shows that money market funds are yielding around 5.28%. We think that is a very attractive area. In fact, if you invest in one of SBH’s 0 to 3 year strategies, the yield approaches 5.50%. We believe it is an attractive time to move money out of short-term investments such as money market funds and lock the investment up for a few years.

Exhibit 3: Yield Gap Between Money Markets and 2 Year Treasuries Has Narrowed

Source: Bloomberg as of 9/21/23.

 

Another area that we find attractive right now is high yield. The high yield market, which includes everything from BBs down to CCCs (i.e., speculative grade bonds), yields over 9% with a short duration of about 3.5 years. If you invest in high quality, the higher end of the high yield market, you are still getting well over 8% with little interest rate risk. So, short duration and high yield are the two areas that we find most attractive.

[Rewey] Jim, you just mentioned money markets. A lot of investors right now are directing their assets towards money markets and T-bills. What are the inherent risks in taking on that strategy?

[Dadura] That has been a great place to be. As interest rates have risen, these areas of the market have held their value and investors have earned a strong return relative to the rest of the bond market. However, it is not without risk. If an investor is in T-bills or money market funds, they have substantial reinvestment risk if rates go lower. T-bills mature in a short period and if rates are lower, the investor is reinvesting at a lower rate. Money market funds adjust very quickly, and an investor’s rate of return can drop quite a bit. Therefore, it is prudent for investors to consider laddering out maturities, which can be accomplished in a 0 to 3 year portfolio that includes short, and 2 to 3 year investments. This would allow the investor, if rates go lower, to lock in higher yields for a period of time. As I mentioned earlier, the 2 year is over 5% so investors can lock in yields that are above 5% for a longer period and not be exposed to that reinvestment risk.

 

To learn more about SBH Fixed Income Strategies, please reach us at (800) 836-4265 or contactus@sbhic.com.

 

This interview was held in October 2023. All opinions expressed in this material are solely the opinions of Segall Bryant & Hamill. You should not treat any opinion expressed as a specific inducement to make a particular investment or follow a particular strategy, but only as an expression of the manager’s opinions. The opinions expressed are based upon information the manager considers reliable, but completeness or accuracy is not warranted, and it should not be relied upon as such. Market conditions are subject to change at any time, and no forecast can be guaranteed. Any and all information perceived from this material does not constitute financial, legal, tax or other professional advice and is not intended as a substitute for consultation with a qualified professional. The manager’s statements and opinions are subject to change without notice, and Segall Bryant & Hamill is not under any obligation to update or correct any information provided in this material.

 

Additional Resources:

Taxable Fixed Income

Tax-Exempt Municipal Fixed Income

Fixed Income Insights

 

The opinions expressed in this video are solely the opinions of Segall Bryant & Hamill or an unaffiliated third party. You should not treat any opinion in this video as specific inducement to make a particular investment or follow a particular strategy, but only as an expression of opinions. The opinions expressed in this video are based upon information considered reliable, but completeness or accuracy is not warranted, and it should not be relied upon as such. Market conditions are subject to change at any time, and no forecast can be guaranteed. Any and all information perceived from this video does not constitute financial, legal, tax, or other professional advice and is not intended as a substitute for consultation with a qualified professional. The opinions and statements are subject to change without notice and Segall Bryant & Hamill is not obligated to update or correct any information in this video. For illustrative purposes only.

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