Posted by Lawrence Gillum, CFA, Fixed Income Strategist
Tuesday, July 26, 2022
In this year’s midyear outlook, entitled Navigating Turbulence, the LPL Research team outlines the reasons why the second half of the year is likely to experience better investment returns across both equity and fixed income markets. But volatility is likely to remain. For fixed income markets, as shown in the LPL Chart of the Day, this year is off to the worst start ever for core bonds (as defined by the Bloomberg Aggregate index), so an improved return environment would be a welcome reprieve from the deep drawdowns investors have already experienced this year.
“The large drawdowns that we’ve seen in fixed income markets the first half of the year may represent the majority of negative returns as inflationary and monetary expectations were quickly digested by the market,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “Looking ahead, we think better days are expected for some areas of the fixed income market (no guarantees of course).” In this month’s Rate and Credit View, we take a more granular look at fixed income sectors that the Strategic and Tactical Asset Allocation Committee find favorable and areas that we think could remain stressed in the near term. Following are high level thoughts on the U.S core bond sectors.
For the US Treasury market, the direction of yields going forward will likely be determined by the continued tug-of-war between fears of outsized inflationary pressures and increasing recession risks. 10-year Treasury yields have more than doubled this year after increasing around 100 basis points off its lows in 2020. The 300 basis point move higher that has already taken place this cycle is the biggest move higher in yields since 1986/87, when rates moved higher by 320 basis points. We expect 10-year Treasury yields to end the year between 2.75 to 3.25% as slowing growth fears really get priced in.
For the mortgage-backed securities market (MBS), performance is largely impacted by interest rate volatility as these securities are AAA-rated and government guaranteed. MBS have an embedded optionality with regard to the timing of principal and interest payments, so higher interest rate volatility equates to higher uncertainty around refinancing and mortgage prepayments. Interest rate volatility, as defined by the MOVE index, has been near historically high levels, however, we expect interest rate volatility to subside as the Fed slows down its aggressive interest rate hiking campaign.
For the corporate credit market, returns have been painful through the first half of 2022. Returns, as measured by broad indices, were down meaningfully with the investment grade (IG) corporate bond index down 14%. Corporate credit is not immune to rising rates and elevated inflation that negatively impact bonds overall, and that has been reflected in returns for corporate bonds that have meaningfully underperformed this year. The steep sell off in corporate credit in 2022 offers more compelling valuations and may be a better entry point for investors.
To get additional details on the U.S. investment grade fixed income market along with additional content on the high yield, bank loan, non-US developed and emerging market debt markets, be sure to check out the most recent edition of the Rate and Credit View.
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