The Weekly Fix: You Don’t Need a Rally To Make Money in Bonds

Welcome to the Weekly Fix, the newsletter that’s all about the beauty of bonds. I’m cross-asset reporter Katie Greifeld.

Either Way, I Win

Much has been made of the bond market’s fight against the Federal Reserve, with the central bank seemingly securing the upper hand in recent days. But investors don’t need to win the war to come out on top.

“Sideways from here, you make money in bonds,” DoubleLine Capital’s Jeffrey Sherman said on Bloomberg Television’s “” from the ETF Exchange conference in Miami this week. “This idea that rates have to go down for you to make money, it’s just not true, especially when you have yield. There’s income out there.”

That’s the beauty of bonds — investors can merrily clip coupons and collect a steady stream of income even if the debt doesn’t actually appreciate in price. That’s the bedrock of many of this year’s bullish fixed-income calls, with yields on Treasury bills at multi-decade highs.

It’s a welcome reminder given how relatively rangebound the Treasury market has been so far this year. Benchmark 10-year yields have plied a 60-basis point range or so since the start of 2023 to oscillate around 3.5%. While 60 basis points is admittedly a rather wide road, it’s small compared to 2022’s about 285 basis point gyration. Rate volatility has cooled as a result, with the MOVE Index dipping below the average of the past year.

Still, Sherman isn’t issuing a blanket recommendation to buy all stripes of bonds. This year’s everything-rally has seen even the riskiest corners of the fixed-income market benefit, fueling a flood of money into junk bond funds. In Sherman’s eyes, that rally isn’t worth the risk

“There’s no wiggle room at 400 [basis points] in high yield,” Sherman said. “You don’t have to take high-yield risk to just get all of your yield. Now you can build a diversified credit portfolio that yields 5 to 6%.”

An Embarrassment of Riches

Other money managers are similarly wary of the rally.

Building risk appetite has narrowed both investment grade and high-yield spreads, shrinking premiums to the point where they no longer compensate for credit concerns. As a result, previously bullish managers are changing their tune as good value becomes harder to find.

“The low hanging fruit has been collected,” Maria Staeheli, a senior portfolio manager at Fisch Asset Management, told Bloomberg News. “It has been evident for the past couple of weeks” that opportunities in new issues in particular “are getting very close to fair value.”

Despite the less-attractive valuation backdrop, bond investors need to find something to do with all the cash they’re taking in. Credit fund managers have absorbed inflows for almost four months straight, and orders outweighed the size of new private-sector issues in Europe’s syndicated bond market by almost four times in February, based on data compiled by Bloomberg.

That could lead active managers to be a little choosier about selecting which wrapper to launch a strategy in, according to Morningstar’s Ben Johnson. The recently launched Vanguard Multi-Sector Income Bond Fund is an interesting case study: it’s an actively managed multi-sector portfolio that invests across blue-chip, high-yield and emerging market debt. 

Importantly, it’s not an exchange-traded fund — a structure in which the manager can’t say no to more money — but an open-end fund, which can turn away new cash if there aren’t any compelling opportunities to choose from. 

“They need to be able to throttle back flows if the portfolio manager can’t do anything with that money,” Johnson, Morningstar’s head of client solutions for asset management, said on the sidelines of the ETF Exchange conference. “It could be that the valuations aren’t as attractive as when a position was initiated or when they last added to it.”

6% Is Suddenly On The Table 

But back to that fight against the Fed. In the past few months, that’s meant betting that policy makers won’t have the mettle to reach the peak rate of over 5% that they’ve projected. Now, after a series of super-strong data and several rounds of hawkish Fedspeak, a fight is brewing at the opposite end of the scale.

As detailed by Bloomberg’s Edward Bolingbroke, traders are ramping up wagers that the Fed’s benchmark rate will top 6% — nearly a percentage point higher than the current consensus. On Tuesday, a trader amassed a large position in options that would make $135 million if the central bank keeps tightening until September. That pattern continued on Wednesday, alongside similar bets. 

Again, that view sits far outside the current consensus. Overnight index swaps show that traders currently expect the Fed’s benchmark to peak around 5.2% in July, followed by easing in the back half of 2023. But even still, Citigroup Inc.’s head of Asia Pacific trading strategies is among those saying that investors need to prepare for the risk of a 6% terminal rate. 

“I think the forward curve market is frankly incorrect,” Citi’s Mohammed Apabhai told Bloomberg’s Tania Chen. “If anything, the rates market is too dovish.”

Macro Hive’s Dominique Dwor-Frecaut is daring to entertain an even more drastic possibility. Judging by an analysis using a Taylor Rule model with data stretching back to 1970, Dwor-Frecaut estimates the Fed will have to boost the federal funds rate to about 8% to truly bring inflation under control. 

Dwor-Frecaut first made this call in March 2022 shortly after the Fed’s liftoff hike, and even with signs that peak inflation has passed, she’s doubling down.

“I’m even more confident about my 8% call after the nonfarm payrolls report,” Dwor-Frecaut, who previously worked in the New York Fed’s markets group, told Bloomberg’s Liz McCormick. “The funds rate has to go much higher than is now predicted. Policy is still very easy.”

Talking In Circles

One of the most circular debates in markets right now is over what signal financial conditions are sending.

Powell addressed the topic in last week’s Fed rate decision: 

Financial conditions have tightened very significantly over the past year. I would say that our focus is not on short-term moves but on sustained changes to broader financial conditions.

Which raised some eyebrows among esteemed market watchers such as Mohamed El-Erian: how is Powell actually judging financial conditions? 

Measures from Bloomberg, Goldman Sachs and the Chicago Fed show fairly meaningful easing over the past several months. While some brush off such measures as giving too much weight to financial markets, they matters when you consider the impact on the wealth effect, companies’ ability to raise fresh capital and what that means for the labor market and demand in an economy that the Fed is very much trying to cool.

Anyway, I took that question to Twitter, which is known as a venue for thoughtful discussion and measured discourse. As Barry Knapp of Ironsides Partners pointed out, it’s very possible that policy makers are using ‘financial conditions’ as shorthand for ‘real rates’; recent commentary from Fed vice chair Lael Brainard and Dallas Fed President Lorie Logan suggests as much.

To that point, real interest rates — which strip out inflation — have risen substantially over the past year. Real yields on 10-year Treasuries currently clock in above 1.3%, versus -0.5% this time last year. But if Powell and company are actually referring to real rates when discussing financial conditions, why not explicitly say so and avoid the potential communication error?

In any case, I appreciated that Morgan Stanley Investment Management’s Jim Caron listed his definition of financial conditions on Bloomberg’s “What Goes Up” podcast: short-term bill yields, intermediate bond yields, BBB credit spreads, equity markets and the trade-weighted value of the US dollar. 

“Those five are the ‘big five’ — those matter most,” Caron told hosts Vildana Hajric and Michael Regan. “I would say that financial conditions have become easier, but they’ve also tightened a lot.”

Bonus Points 

• Track lawmakers’ stock trading with these two ETFs
• Steve Eisman of ‘Big Short’ fame sees a new paradigm for markets
• Coinbase shares tumble as SEC cracks down on crypto staking