Weitz's Fixed Income Insights: Bonds Are Back, Redux

A year ago, we penned a piece titled “Bonds Are Back / Return of Income” after a brutal 2022. It seems fitting to revisit since, for much of 2023, fixed income investors were smarting from a seemingly relentless increase in U.S. Treasury interest rates across the yield curve (as well as other segments of the bond market) as the Federal Reserve instituted four additional short-term rate hikes to combat declining-but-still-high inflation readings. Broad interest rate declines in early 2023, accelerated by historic regional bank failures that caused massive deposit flight, reversed by mid-year and began a climb that saw trough-to-peak changes in U.S. Treasury interest rates of approximately 1.5% (150 basis points) across the yield curve, from 2-year to 30-year bonds. In October 10-year and 30-year Treasury bond rates briefly breached 5% for the first time in more than 16 years. However, midway through the fourth quarter, ebbing inflation levels, a slower pace of employment growth, and the long-forecasted Fed 'pivot' or pause in its monetary tightening policy, propelled a powerful fixed income rally. By year-end, fixed income and equity investors were seeing strong overall returns, as the growth below highlights. Treasuries managed to avoid a three-year negative return record by posting modest positive results — with every other credit-sensitive asset class (e.g. investment-grade and high-yield corporate bonds as well as leveraged loans) generating solid results.

Overall, 2023 was a very tumultuous year from an interest rate perspective (down early in the year, up meaningfully into the fourth quarter, and back down to close the year). But as the graph below shows, if you had fallen asleep (a la Washington Irving's Rip Van Winkle) at the beginning of 2023 and woken up at year-end, you might have easily thought 'not much happened' as the 10- and 30-year Treasury interest rate had barely changed. The MOVE index, which measures U.S. bond market volatility, would tell a different story as volatility markedly increased from longer-term averages (3, 5, and 10 years). While some rates (like 10- and 30-year Treasuries) started and ended the year at the same place, much like a rollercoaster, the journey made for a thrill ride to remember.

The graph below shows the ups/downs (rollercoaster style) of effective yields for the broad high-yield (blue) and investment-grade (red) indexes. As the earlier total return chart shows, both high-yield (HY Corp) and investment-grade bonds (IG Corp) performed well in 2023. Year-over-year, broad investment-grade spreads (as measured by the ICE BofA index below) declined 34 basis points while broad high yield spreads (ICE BofA index below) declined 142 basis points (one basis point is equal to 0.01%). Despite the shockwaves caused by three bank failures that were the largest (cumulatively) in U.S. history, credit markets quickly digested / sluffed off systemic concern risks, largely resulting from the massive support of depositors by the government and FDIC.

“The only function of economic forecasting is to make astrology look respectable”
—John Kenneth Galbraith, economist

The table below highlights the shifting nature of economic forecasts. It portrays the Federal Open Market Committee's (FOMC) quarterly Summary of Economic Projections (SEP), often called the 'dot plot' whereby FOMC participants provide an assessment of their views on appropriate monetary policy. It shows that as of September 20, ten members thought Fed policy, specifically the fed funds rate, needed to be tightened further by the end of 2023. By December 13, less than three months later, NO member was in favor of further tightening. Additionally, in September, ten FOMC members thought the fed funds rate would still be above 5% by the end of 2024. Now only three think that — with one outlier who thinks that the fed funds rate will drop below 4% in 2024. Quite an interesting development from a group that kept repeating inflation was “transitory” in 2021. The Galbraith quote above and the following from Douglas Adams — writer of The Hitchhikers Guide to the Galaxy — sum it well: “Trying to predict the future is a mug's game”.

Our View

We've pointed out repeatedly in the past that we strive to avoid the forecasting business and instead focus our efforts on sector and security selection, investing assets one at a time in those areas that we believe have the most favorable risk/reward outcomes. How do we do this? By casting a wider net across the fixed income landscape — particularly across securitized products that we believe have meaningful structural enhancements and where higher income relative to bond indexes is available. We believe this approach gives us a meaningful advantage in today's environment.
In addition, our research efforts involve significant 'boots on the ground' activity, as we seek favorable investment opportunities and conduct surveillance on current holdings. For instance, in 2023, the fixed income research team attended 16 conferences that included approximately 90 one-on-one meetings with management teams / sponsors — both current and prospective investees. This doesn't count scores of phone and virtual meetings as part of our overall vetting process. These 'shots on goal' may not guarantee success, but they are a critical part of the overall vetting process as we evaluate the important qualitative aspects of any investment that has compelling quantitative attributes.

Normal for Longer?

A significant amount of press has focused on the possibility of interest rates staying “higher for longer.” Having painful memories of what approximated 'zero forever' during the ZIRP (zero interest-rate policy) days, we'd welcome a return of some semblance of normalcy to interest rates overall, where rates are determined in a world less manipulated by central banks. This would benefit investors and decision makers of all types, from savers in money market funds to investors of capital all along the yield curve. And ultimately, it would lead to more rational investment decisions à la philosopher/economist Adam Smith's “invisible hand” (metaphor describing unseen forces of self-interest that impact free markets).

As we embark on a new year where everyone's year-to-date investment results are reset to zero, it certainly is plausible that the strong bond market rally to end 2023 may have borrowed from 2024 returns (the first week of the new year seems to support this). Either way, we believe the prospects for fixed-income investors, coupled with an easing (if not plateauing) inflationary backdrop, continue to provide a compelling environment for both nominal and, in particular, real (after inflation) return opportunities. If this describes “normal for longer,” we can be tempted to reiterate, cliché or not, that 'bonds are back' — especially from an income perspective.