The sharp rise in interest rates has punished duration-heavy fixed income assets, but even high yield bonds were not spared thanks to generationally low yields.
Long a source of comfort for investors, the “Fed put” may not be as readily available as it has in the past as the central bank battles inflation levels not seen since the early 1980s.
Central bank intervention over the years has blunted the peaks and valleys of the credit cycle, denying markets of the cleansing catharsis and reallocation of capital that characterizes a cycle’s bottom.
If history is any guide, the multiple inversions of the yield curve this year augur ill tidings for both the economy and the high yield bond market, though there are potential mitigating factors.
- While such an uncertain environment encourages downside risk mitigation, in our view, idiosyncratic opportunities may emerge should markets punish bonds indiscriminately.
After many years of mostly supportive conditions, fixed income assets today appear to be pinned in a vise of expectations—of persistently high inflation, of more restrictive monetary policy, of slower economic growth, of mounting debt piles, of ongoing geopolitical discord. Bond yields ascended steadily in response, punishing duration-heavy assets like Treasuries, investment grade corporates, emerging markets debt and agency paper during the first half of 2022. However, the generationally low yields that preceded the selloff left even high yield bonds vulnerable to duration risk for the first time in their brief history.
Though the pain has been acute across markets, there are signs that we may be in only the early stages of the credit cycle’s turn. Decades of monetary accommodation along with fiscal permissiveness created the financial market equivalent of serene weather, suppressing market volatility and preventing the cathartic cleansing of failed business models that accompanies the end of a credit cycle. With policymaking agility now hamstrung by multidecade-high inflation rates, it seems that the bill for this period of relative calm may be coming due.
“In fair weather, prepare for foul,” advised seventeenth century English polymath Thomas Fuller, and we’ve long been inclined to agree with this sentiment. Rather than searching for a port in the storms that inevitably arise, we continually underwrite our portfolio exposures in an effort to maintain appropriate levels of risk based on the fundamental backdrop and spread compensation available in the market.
For Auld Lang Syne
January 2022 began with a bang, as it appeared investors had resolved to shed duration risk in the face of unrelenting inflation pressures and financial conditions that had already begun to tighten. Unlike most New Year’s resolutions, however, this one has had staying power. The 4% loss posted by long government bonds in January, for example, was just the start of a first-half rout that sent the Bloomberg US Long Treasury Index 22.3% lower amid a
broad repricing across asset classes.1 Treasury yields surged across maturities, as shown in Exhibit 1, but pulled back a bit in the back half of June as focus shifted to downside economic growth risks.
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