2019 Bond Roundtable: Bonds Prove Their Value in a Volatile Year
After several years of smooth sailing, even in the face of gradual tightening by the Federal Reserve, bonds came under some pressure in 2018 as rates began to move meaningfully higher. But as equities ran into increased turbulence, the fixed income market demonstrated its diversification power, as investors sought refuge in bonds.
Fixed income is likely to continue to play a protective role in portfolios in what may be another volatile year for global markets. Municipal securities, in particular, remain attractive for those in high-tax states. For more on what may be ahead, we gathered bond portfolio managers John Queen and Mark Marinella, along with municipal analysts Lee Chu and Ellen Gordon. Below they discuss the macroeconomic drivers they are watching and reveal where they are finding compelling values that others tend to overlook.
While bonds ended the year in fairly good shape, we definitely saw an increase in volatility during 2018. What were some of the key factors impacting the market?
John Queen: I think much of it had to do with the fact that we essentially had an economy of two tales, namely a positive beginning and a challenging ending. We started 2018 in the midst of a synchronized global expansion. Growth was stronger in the U.S. than in most other places, but China was also doing well, and Europe and Japan were showing signs of improvement. Given economic vigor in the U.S., the Fed continued to raise interest rates and reverse the quantitative easing it had initiated after the 2008 financial crisis.
Financial conditions tightened around the world as we moved through the year, putting pressure on some of the economic numbers that came out later in the year. This was exacerbated by trade tensions between the U.S. and China, questions surrounding Brexit and early signs of economic slowing. As sometimes happens in the financial world, the markets went from focusing almost entirely on positives to dwelling largely on risks. But in my view there are still plenty of reasons for optimism — the U.S. economy remains fairly strong, and the consumer is in great shape. I think investors at some point will recognize this and take a more balanced approach.
While bonds certainly held up better than stocks, they didn’t do as well as some might have expected during times of equity selloffs. Is fixed income still an effective diversifier in this environment?
Mark Marinella: Absolutely. It’s important to understand the forces at work in the economy that have weighed on the bond market. The Fed hiked interest rates in every quarter last year. The pace of hikes is expected to slow this year, but I still think there will be one or two moves. That is a tough backdrop for fixed income. But I actually think bonds held up very well given these challenges.
Queen: Global central banks are reversing the most aggressive monetary policy in the history of global economies. There are negative interest rates in Europe and Japan. Yet bond returns have held up well. In fact, on days when the stock market has done poorly, bonds have generally done exactly what one would expect. That’s pretty good when we consider the big picture.
Mark, what’s the outlook for the municipal bond market?
Marinella: If you think back to a year ago, there was concern that the federal tax overhaul would pose a threat to the muni market. People were asking if there would still be robust demand for these securities given the lower rates. Well, as they have done year in and year out, decade after decade, municipal bonds were just fine. The demand for munis did not go away. In fact, there’s still a great need for the tax exemption they provide, particularly in very high-tax states such as California and New York, given the limit on state and local tax deductions that is now in effect.
Ellen Gordon: It’s not as well known, but corporations are heavy buyers of municipal securities. Given this, there was also concern that lower corporate rates would dampen demand. But that didn’t slow the market down either, despite the new supply that came to market late in 2017.
Marinella: Actually, that was an important factor that proved to be an overall positive. Anxiety over tax reform sparked a lot of municipal issuance in late 2017 as governments and other issuers hurried to sell their bonds before the new law took effect. There was less issuance in 2018 — in other words, there was lower supply — and it seems as though that will remain the case this year. At the same time, demand is expected to remain heavy, particularly among retail investors. The combination of moderate supply and solid demand has been a positive for munis.
Will the Fed throttle back on rate hikes in 2019, as some have suggested? If so, would that be a troubling sign that indicates underlying weakness in the economy?
Queen: My view is that we’ll probably get one or possibly two additional quarter-point hikes in 2019. But that doesn’t necessarily mean there’s an imminent threat to the economy. We have an extremely tight job market and rising wages, so the consumer is in very good shape. In fact, retail sales are booming. Certainly, some interest-rate-sensitive parts of the economy aren’t doing as well and corporate investment is beginning to wane. The Fed is going to have to weigh all of that and be careful about raising rates too quickly, thus denting the economy. The danger of a breakout in inflation seems to be low, though, so that may reduce some of the pressure on the central bank to be aggressive.
Marinella: It definitely feels like the path forward for rate hikes has changed recently, and the Fed itself has signaled as much. The Fed funds rate may go up this year, but the arc is likely to be less steep than was assumed even a few months back. From a bond market and investment perspective, what we desire most from the Fed is transparency. We want policymakers to be clear on what their plans are and to tell us what they’re basing decisions on. Fortunately, they have been reasonably transparent. I’ve been able to understand which way they’re going and why. That makes it much easier for us as professional investors to develop plans.
There was a lot of talk in the media about the flattening yield curve and the chance that it might invert. What does that mean, and what is its significance to the market?
Queen: In simple terms, an inverted curve means that short-term interest rates yield more than long-term rates. That’s the opposite of the way it is normally, when long-term rates yield more because of the extra risk involved in tying up money for a longer period of time.
There’s a belief among some that a flattening yield curve foreshadows a coming recession. I personally don’t think it foreshadows anything in particular. For the last 10 years, it has seemed as though a recession was going to happen in two years. This still appears to be the case, with some predicting that we could see a recession start in 2020. But among many other factors, the Federal Reserve’s substantial bond buying in the last decade has distorted some of the messaging that the yield curve might otherwise be sending, at least in my view.
How have you positioned the portfolios you manage given the current landscape?
Marinella: Coming into 2018, there were a couple of really important themes. One was protection against rising interest rates. Because of that, for most of the year portfolios were underweight duration, making them less sensitive to interest rate risk. As we came into the fourth quarter, we got back to what I call a more neutral level, because I don’t think we need to provide quite as much protection against interest rates.
In addition, our focus on credit quality has remained consistent. We don’t want to subject portfolios to excessive credit risk — the threat that a borrower defaults — so I’m staying higher in quality, particularly compared to some other managers in our peer universe.
Lee Chu: On the municipal side, we’ve taken a defensive approach to general obligation bonds. Overall, we’re trying to pick what we view to be the most well-positioned securities. I use a twin-pillared framework to analyze state and local bonds, based on recession preparedness and pension vulnerability: If a recession were to strike, which credits have the most financial cushion, taxing ability and, perhaps most importantly, willingness to meet their aggregate obligations? This framework keeps me away from general obligation bonds in states with low reserves, poorly funded pension plans, weakening demographics and growing fixed costs, as an example. Of course, the credit work is tied in with a judgment on valuation: Is the market paying us to take the risk? In many cases, general obligation debt provides less compensation for a sector that I believe is less defensive than revenue bonds — such as water/sewer or electric utilities — for later stages of the economic cycle. These dynamics help keep exposure to state and local general obligation debt meaningfully lower than the investable universe.
Gordon: We try to find issuers that are fundamentally strong or have improving credit characteristics that are underappreciated by the market. Given the breadth of our research capabilities, we try to identify securities that can add incremental yield. That being said, we take advantage of short-term tactical opportunities as they occur. A great example is Illinois. There is a lot of negative sentiment about the state given its prolonged state budget challenges. But through our research I’ve identified attractive opportunities, such as prominent colleges that got penalized simply for being based in Chicago. These are attractive borrowers whose repayment ability isn’t tied to the state’s finances, yet they get painted with the same brush.
Let’s discuss some of the other sectors you are attracted to.
Gordon: Another area I’ve been drawn to recently is hospitals — especially, small hospitals because they are potential acquisition targets by larger health care systems with strong financial footing. I look for hospitals that have a high market share with strong commercial revenue reimbursement. I think there’s a lot of opportunity because we’ve seen significant merger activity in recent years and I don’t think that will stop.
Given the crosscurrents in all financial markets, how should investors view the big picture for bonds?
Marinella: Investors tend to worry about their fixed income investments whenever the Fed tightens. That’s understandable given the immediate pain this can cause. But over longer periods of time, as you reinvest interest and the proceeds of maturing securities at higher rates, you get paid higher yields, and that’s good for bond investors.
Queen: It’s important to remember some of the essential functions that high-quality bonds are designed to perform. They provide income, help preserve capital and serve as a source of diversification against equity risk. They did all of those things in 2018, and I expect that to continue. That’s something important to keep in mind given the recent volatility in the equity market.
The above article originally appeared in the Winter 2019 issue of Quarterly Insights magazine