SBH Investment Summit:
Fixed Income Overview

[Carolyn Goldhaber] Welcome to the SBH Investment Summit. I’m Carolyn Goldhaber, President of Segall Bryant & Hamill, and today I’m here with Jim Dadura, Director of Fixed Income. Jim, thanks for joining me today.

[Jim Dadura] Hi Carolyn, thanks for having me.

[Goldhaber] It’s been such a historically lousy year in the bond market, being down at one point over 15%. Can you talk about how we got to where we are today?

[Dadura] I’m happy to. The bond market had a bad year for two reasons. One is yields. Yields had been dropping for over a decade, and they went even lower in 2020 due to the pandemic. When we started 2021, yields were the lowest levels they’ve been in decades. While yields have been declining, we also saw interest rate sensitivity is now at the highest level we’ve seen in decades. The chart you see on the page shows the relationships between yield and interest rate sensitivity over time. Yields are represented by a gray line, and interest rate sensitivity is represented by the blue line. We use duration to measure interest rate sensitivity. Duration tells investors how much the price of a bond will move if interest rates go up 1% or go down 1%. Back in the ‘90s on the left side of this chart, yields were quite a bit higher than duration, and what that did was that gave investors a cushion in case interest rates went higher, and experienced price losses. So, if you look in the ‘90s, even if rates went up 1%, you would generate a positive return. Through the last decade, we saw that yields and interest rate sensitivity collapsed, or they became very similar, but there is still some yield cushion in the market. What happened over the last decade-plus is that interest rates have steadily fallen, and this is because central banks have been keeping interest rates low. They certainly lowered them to zero, and negative during the pandemic. And while they were doing this, corporations and governments took advantage of these low rates, and they actually extended their maturities. They issued more debt with longer maturities. This increased the interest rate sensitivity of the market. So, when we got to the end of 2021 and beginning of ‘22, the market was priced for perfection, and we had durations of over 7 years, meaning if rates went up 1%, you would lose 7% in value, and it was only offset by a yield of close to 1.5%. And that’s why we got to this place in the market.

[Goldhaber] Wow. And in November, the fixed income market came back and there was a bounce back. Do you think this recovery’s going to stick?

[Dadura] Well, the bounce back was spurred by a lower-than-expected core CPI print, or inflation print that came out in early November. The recovery was pushed also by the Fed, who indicated that they’re going to downshift from interest rate hike pace of 75 basis points, or three quarters of a percent at every meeting which they’ve done for the last few meetings, to a pace of 50 basis points in the next December meeting. So, their pace of hikes was going to slow. So, the market responded very favorably to this. We think this recovery can last for a little while here, but we’re a little concerned about volatility in 2023. The reason that we’re concerned about volatility is that the market expects the Fed to do something different than the Fed says they’re going to do. The chart on this page shows expectations for interest rates that are in the market. …You’ll see the chart shows interest rates going up or Fed rates going up for a couple of meetings, and then coming back down. The market thinks the Fed’s going to cut rates next summer. Meanwhile, the Fed has said they’re going to keep rates high for a long period of time, and they’re trying to get the market to believe this. At the end of the day, we think volatility would be caused by the Fed’s data dependency, and the market’s data dependency. We saw this month’s rally was triggered by a low inflation print. We think next year we’re going to be surprised by those inflation numbers to the upside and to the downside. These numbers have been historically volatile. The core CPI printed 0.3% for October, and that caused this rally. It also printed 0.3% in June, which caused a huge rally in July only to be reversed when the subsequent CPI numbers went higher. Our proprietary models show that companies are still increasing prices. In fact, 96% of the companies in our coverage universe that are not Financials, Utilities, or Energy companies, so basic companies, 96% raise prices. So we still think that …there’s a chance for to see surprise prints in CPI. We also see that the consumer is very strong. Wage growth has been strong, and even though we’ve seen some slowing down in the economies, we haven’t seen that in the labor market. And wage growth will also cause surprises to the CPI. So, we think 2023 could be a pretty volatile year because the market at expectations are for the Fed to be cutting next year, and the Fed says they’re not going to.

[Goldhaber] And with what has happened, with the potential for volatility in 2023 that you mentioned, where do you find the opportunities in this space?

[Dadura] We really like the areas within the fixed income market that offer a yield cushion relative to their interest rate risk. So, the chart that we showed earlier showed that yields were lower than durations. We’re looking for sectors where yields are higher than duration, or interest rate sensitivity measures. Two of those areas that we find very attractive are short-term investment grade, where you can get yields over 4%, and durations are under 2 years, so you do have quite a yield cushion. We also like the high yield market, particularly the high-quality end of the high yield market, where yields are over 8% and the durations under 4 years. So again, you have a big cushion in case interest rate volatility picks up or interest rates go higher. You can still have some protection against having a very bad year. You can still generate a high return even if rates go a little bit higher. We also see similar opportunities like that in short municipal bonds. And the other area, little different that we see interesting opportunities in, is LDI or Liability Driven Investing. The reason we see opportunity in that space is because long-term corporate yields are at levels we haven’t seen in years. And meanwhile the pension funds are more and more funded, so they have the cash to deploy into that space. So, we think that’s a very attractive place space as well.

[Goldhaber] Great. Well Jim, thanks so much for sharing your insights into the bond market with us today. And if anyone has any questions, feel free to reach out to your SBH Sales Rep.