Opportunities on the Horizon: Investing Through a Slowing Economy

Thematic updates | WEALTH OUTLOOK 2023 | MID-YEAR EDITION | 35 Bonds are indeed back. The 2-year Treasury yield and 10-year Treasury yield are roughly the same from the start of the year through May 26th, though yields dipped significantly for a period in the early spring. This price action evidenced Treasuries fulfilling their traditional role as a general “flight to quality” asset, most likely due to heightened fears during the US regional banking crisis. Recent optimism in late May over the debt ceiling and more optimistic economic data brought yields back to roughly the same yields as the beginning of the year, offering investors a chance to own bonds at these more favorable higher yield levels. Year-to-date, the Bloomberg US Aggregate Index and the Bloomberg US Corporate Bond Index have each risen by roughly 1.5%, driven largely by interest carry. Investor demand for higher yields remains robust, especially when compared to the last decade. Recent US regional banking stress further reduced market expectations for rate hikes, though this has partially reversed some in recent weeks. Even high-yield bonds have performed well, despite concerns over a possible future banking “credit crunch” and recession in the US. The Bloomberg US Corporate High Yield Bond Index is up 3.3% year-to-date. What should we expect from bonds going forward? The inverted yield curve points to shallow recession and subsequent rate cuts. Meanwhile, investors are enjoying the short end of the yield curve with T-bills paying 5.25% for 1-year maturities and 5.3% for 3-month bills. These rates are almost 150 basis points more than longer-dated Treasury notes. We think that the allure of high short-term rates has dampened demand for longer term fixed income securities. The focus on “income now” ignores the fact that when unemployment rises, inflation slows and consumer demand fades, the Federal Reserve will likely begin cutting rates aggressively. Currently, the market is pricing future rate cuts that may bring the Fed Funds rate to 3.5% by the end of 2024. Thinking ahead may be rewarding In each of the three recessions between 1990 and the COVID-19 pandemic, the Fed cut interest rates by at least 500 basis points. While we do not expect that degree of monetary easing, even cuts of 250 basis points could reduce short-term T-bill yields and make them less attractive than the current yields of longer-term bonds. This is why we believe investors should seek to rotate capital into longer duration bonds sooner rather than later. In addition to adding duration, investors should consider adding intermediate duration investment grade corporate bonds or similarly rated longer duration municipal bonds. Investment grade credit spreads offer an additional 100-150 basis points of yield depending on tenor. Higher-rated corporate bonds can offer 5% to 6% yields alongside T-bills and deposits ( FIGURE 1 ) . FIGURE 1 : Corporate Bonds Yields Higher than 2-Year Treasury Yield 0 2 4 6 8 10 ‘01 ‘03 ‘05 ‘ ‘07 ‘09 ‘11 ‘13 ‘15 ‘17 ‘19 ‘21 ‘23 Yield (%) US Corporate Bond (1-3yr) Yield 2yr US Treasury Yield ‘ Source: Bloomberg as of May 26, 2023. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Past performance is no guarantee of future results. Real results may vary.