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October 2022

Taxable Strategies: Charles Luke Q3 2022

Key Points

  • The taxable US bond market is experiencing high levels of volatility
  • Low, post-pandemic yields left the bond market defenseless against rising interest rates
  • Forward returns for US High Yield and US High Quality bonds are balanced for the first time in a decade

Taxable bond markets experienced volatility in the third quarter associated with previous recessionary environments. The key was and is the historically large increases in the Fed Funds target rate and a Federal Reserve shift to data dependency, as opposed to clear forward guidance.

A fast-paced rally in US Treasuries bled through to July, eventually bottoming at 2.52%, which set the stage for a rapid increase of 1.5% by quarter’s end.1Bond volatility was 55% higher relative to Q1 2020 and 63% of the Q3 2008 average.2

Absolute returns, which measure YTD performance across fixed income, are the worst on record, including the 1970s, but economic stress is not the culprit for the negative returns. Instead, the largest impact is coming from higher interest rates and the rapid removal of liquidity. Ultra-low post-pandemic interest rates sapped the bond market’s ability to defend against the sharp rise in yields. The counter-argument is that the U.S. bond market is now yielding 4.7% and offers the best outlook for returns in more than a decade.3 Yields are 2.7% over the 10-year trailing average.4

High yield sectors of the market outperformed high quality, especially sectors with low interest rate sensitivity such as structured credit and leveraged loans. Relative to high quality, structured credit, high yield and leveraged loans outperformed by +3.3%, +4.1% and +6.1%, respectively.5 Also, credit stress usually associated with a slow growth environment was absent. We estimate 60% of the pullback in the latter half of the quarter was due to interest rates, not credit.6 Despite the benefits of holding opportunistic income in portfolios in 2022 so far, we believe the forward return profile is now balanced between high quality and low quality bonds.

Given these dynamics, we recommend a reduction in high yield exposure. The increased probability of a recession and historical correlation between high yield and equity markets is likely to result in negative returns. We also continue to recommend investments in short-term pockets of the market for investors focused on capital preservation.

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