Game of Knowns: The Bond Market in 1H-2023

While tremendous political, economic, and market uncertainty remains, here are ten reasons investors can take comfort in the bond market to start 2023:

1. The plumbing remains intact despite the Federal Reserve’s (Fed) 17 25bp hikes and a period of prolonged rate volatility not experienced since 2009. This speaks to the scaffolding the Fed has built around the funding markets using monetary policy tools such as the IORB (Interest on Reserve Balances), SRF (Standing Repo Facility), and RRP (Reverse Repo Program).
2. This has allowed for high quality bond spreads to widen in an orderly fashion. Corporate spreads and interest rates have been more correlated in this market swoon than they have in the recent past. Yet, we haven’t seen a complete blow-out in spreads to date.  This implies that this sell-off is more about buyers on the sidelines than it is about a deluge of distressed sellers.
3. And kept the housing market on solid footing despite the dramatic rise in mortgage rates. Both the mortgage refinancing activity and housing turnover have slowed substantially over the past year.  The silver lining is that fixed income markets continue to treat mortgage-backed securities as very high-quality complements to corporate bonds.  Rightfully so, the equity build-up in homes is far higher now than it was prior to the 2008 Financial Crisis.
4. But the Fed still has ways to go to “normalize” monetary policy. They kicked off “normalization” by hiking their short rate into restrictive territory, but right sizing the balance sheet will take longer. Yet the goal isn’t to shrink it to a dollar amount such as $4 trillion (it’s pre-covid size).  Instead, the Fed will likely measure the success of Quantitative Tightening by how much it reduces its size relative to the size of the growing economy.  Given the current pace of GDP growth (2.9%/year) and the current pace of Quantitative Tightening (0.9%/month), the balance sheet will shrink from its current level of 33.6% to 22.5% of GDP by year end 2025. This would bring the balance sheet back to a “normal” pre-covid percent of GDP even though it will still be over $6 trillion in size.
5. In the meantime, traders are adjusting to a “new liquidity normal”. For most of the past twenty years, market makers have enjoyed liquidity tailwinds from Quantitative Easing, and, prior to that, Shadow Banking expansion.  The knock-on benefits extended to the far corners of the bond market and invited marginal investors to dip down the credit and liquidity spectrum.  Now, traders face a new reality. Many of those marginal investors have fled, leaving the more resilient bond investors to demand more protections in indentures and better pricing terms at new issue.
6. And the wider liquidity premiums in spreads invites more active security selection. Many high-quality, off-the-run corporate and securitized sectors are ripe for bottom-up relative value.  Case in point: Wendy’s International has both high-yield unsecured and investment-grade ABS outstanding.  The high-yield issue (WEN 7% 12/15/25) is rated B- by S&P and trading with a 6.3% yield.  Wendy’s securitized franchise ABS (WEN 2019-1A A2I) is rated BBB by S&P and trading with a 6.5% yield.  Clearly, relative value can reward the active bond manager canvassing both sectors.
7. Overall, high-quality bonds sport attractive real yields once again. The Fed has pushed yields up enough such that  high-quality bond prospects are now competitive with other asset classes across our broad economy. For example, 5yr on-the-run TIPS presently trade at a 1.8% yield. If you add the spread of the Bloomberg Intermediate Corporate Index (1.2%), the all-in real yield increases to 3.0%. This is above the current pace of real GDP, suggesting that bonds are an attractive option for the marginal investment dollar.
8. Meanwhile the LIBOR-SOFR Transition is on track. The CME’s development and facilitation of SOFR futures and options markets has provided the needed forward SOFR curve for fixed income valuation purposes. The next step is to transition the Eurodollar Futures market over to SOFR (April), then sunset LIBOR altogether (June).
9. This is good news for the CLO market, which recently surpassed $1 trillion in size. This makes CLOs the largest floating rate sector in U.S. Dollar fixed income.  But those bond investors who sought shelter in floating rate CLOs know they are no panacea.  Transitioning reference rates, regulatory concerns, and maturity extensions have depressed dollar prices and further nuanced an already complicated sector.
10. Finally, inflation in the most important economic price, the price of money, has resurrected cash as an asset class. “Risk-free” short bonds now pay handsome yields with little mark-to-market risk. A year ago, $1,000 face of a 12-month T-bill would’ve cost $996 (0.39% yield) and today it costs $956 (4.61% yield).  That’s far less of a cash outlay to construct ladders, cash matching, and targeted maturity strategies.

It’s now 2023 and the sun may be rising again for the bond market!