If the latest Fed rate hike and regional banking jitters have you worried about your fixed income portfolio, you're not alone. Tighter credit conditions and market volatility likely lie ahead. So how should fixed income investors react?
Go long and go high—as in long duration and high quality, Schwab experts suggest.
In past cycles, as the federal funds rate peaked, intermediate-term bonds' total return tended to outperform that of short-term bonds during the subsequent 12 months. That's why adding duration might make sense now. With markets anticipating a pause in rate hikes, and as more stringent lending standards start to burden economic growth, intermediate- to long-term yields could continue to trend lower while their prices trend higher.
"Long-term yields can be held down by the fact that every rate hike intensifies the risk of recession and potential financial problems," says Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research. "The credit tightening issues are with us already and will probably continue to intensify."
Fixed income investors can extend duration by adding intermediate-term bonds to their portfolios to lock in yields, allowing them to control cash flow for five to seven years at rates of 3.5% to 5% using investment-grade corporate bonds.
Kathy suggests investors avoid trying to time the market on the short end, where yields are higher. Anyone snapping up shorter-term fixed income now might face reinvestment risk if yields fall by the time they expire. By going intermediate, you sacrifice a bit on yield but gain on the time element.
Even if the most recent rate increase is the last for a while, lending will probably continue to slow, warns Kevin Gordon, senior investment strategist at the Schwab Center for Financial Research.
Fed funds target rate rising
Source: Board of Governors of the Federal Reserve System.
As of May 2023.
Tougher credit conditions tend to weaken the economy, but the impact could be worse for companies that are more dependent on borrowed money to expand their businesses and hire new employees. That's why fixed income investors might want to also consider investment-grade over high-yield corporate bonds.
Market still builds in rate cuts, but Fed stalwart
While Fed Chairman Jerome Powell hinted in his May 3 press conference that rates won't fall this year unless there's a major banking or financial crisis, investors don't buy that forecast. The probability of at least one rate cut before the end of the year stood at 100% as of early May, according to the CME FedWatch Tool. That implies a sharp economic contraction later this year, if not a recession. U.S. Gross Domestic Product (GDP) grew just 1.1% in Q1.
"The Fed, by continuing to tighten into tightening conditions at a rapid rate, is contributing to financial instability," says Kathy. "They seem very intent on this one focus – inflation, and they're backward looking in the metrics they've been watching. I'm concerned that by overcorrecting in a time of fragility in the economy and the financial system, they risk making things worse and going from one extreme to another."
Commercial and industrial loan environment slowing
Credit conditions are one metric investors can watch for signs of economic regression. Though the broader credit markets remain stable, there's already been stress in the credit markets for regional banks. That's a pocket of strain seen first in April and then again in early May when troubles centered around PacWest (PACW) and Horizon Bancorp (HBNC).
April's quarterly Senior Loan Officer Opinion survey from the Federal Reserve indicated the loan environment starting to slow. The percentage of respondents reporting a tighter loan environment is elevated from the historic average, and demand for commercial and industrial loans fell, the Fed said.
Source: Senior Loan Officer Opinion Survey and Board of Governors of the Federal Reserve System.
As of May 2023.
"Banks reported expecting to tighten standards across all loan categories," the Fed report said. "Banks most frequently cited an expected deterioration in the credit quality of their loan portfolios and in customers' collateral values, a reduction in risk tolerance, and concerns about bank funding costs, bank liquidity position, and deposit outflows as reasons for expecting to tighten lending standards over the rest of 2023."
The survey shows the percentage reporting some tightening ticked lower to 42.9% while the percent reporting considerable tightening rose to 3.2%.
Kathy notes that the survey was conducted before the most recent turmoil in the banking sector, so it is likely that banks are still tightening standards.
"The Senior Loan Officers Survey for Q1 confirmed that credit conditions are tightening," she says. "There was a huge drop in demand for loans with the index falling to levels normally seen in recessions. The implications—slower growth and heightened risk of recession."
More stringent loan standards don't necessarily mean a credit crunch, of course. How will investors know if the situation deteriorates further, considering they didn't get much notice back in March that regional banks were about to experience tough times?
"Usually, the signs are in the high-yield bond market," Kathy says. "Credit spreads start to widen. Currently they are just hanging in around 450 basis points, which is near the long-term average. But if investors start to pull back from the riskier parts of the market, then that spread would likely widen by at least 150 basis points."
Credit market hanging in despite regional banks
Aside from the regional bank struggles, the credit market is showing signs of life. In the high-yield space, after nearly a three-week hiatus at the start of April with essentially zero issuance, HY new issuance has resumed.
But credit conditions might worsen if the Fed continues to fight the market with additional rate hikes. Don't rule that out, whatever the market might be telling you.
"The Fed is not in pause mode yet, and I think that is one of the main takeaways from the May 2–3 Federal Open Market Committee (FOMC) meeting," Kevin says. "Powell was careful to keep the door open (even if slightly) for future rate increases, given several mentions of a tight labor market and still-high inflation."
That's one reason why now could be the time for investors to take a close look at their fixed income holdings and reposition if there's any risk.
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