The possibility of stagflation has reappeared in the news, afier nearly a forty-year hiatus. Stagflation is an economic cycle characterized by slow growth, a high unemployment rate, and high inflation. Presently, two of the three factors can be seen in the economy with the exception being high unemployment. With this in mind, we’ve begun to see the longer end of the yield curve come down and even invert (the 30Yr, 10Yr, and 5Yr Treasury yields are now below the 2Yr yield). These inversions reflect the fear of a recession and could indicate a peak in longer term interest rates.
We saw this development as a possible buying opportunity for bonds over the summer. Overall, in the recent rebalance of our client portfolios, we increased the overall bond allocation from 24% to 30% in our typical growth and income portfolio (a 25% increase to the bond allocation).
At this point, we expect to gradually increase our bond allocations during the remainder of the year, as rates likely continue to rise. While no one has a crystal ball, we think a determined Fed will address inflation, and as their declared policy continues, there should be opportunities to cherry-pick accordingly. We do not believe that higher rates are sustainable in the long run, which is why we have begun building bond ladders and have added to duration as we cautiously look to lock in these higher yields.
With the current “risk-free” rates of 2Yr, 5Yr, 10Yr, and 30Yr Treasuries now around 4%, and credit spreads over Treasuries of approximately 1.6% on investment grade corporate bonds and 5.5% on high yield bonds, the prospect of building larger bond allocations is beginning to garner more interest once again.
Are Discounted Bonds A “Deal”?
As bonds are constantly repriced to reflect the current issue and rate environment, purchasing corporate bonds at significant discounts can be reduced to bond math. For example, if a high-quality, five-year, 2% coupon corporate bond issued at par six months ago were to be issued in the current market, it would need to be offered with a 5+% coupon at par to offer a 5%+ yield. This is based solely on the fact that the yield on a five-year U.S. Treasury bond has risen by over 2% in the past nine months. To adjust for the current issues at a higher rate, the bond issued six months ago is now sold in the secondary market at a discounted price to match a current yield of 5%+.
In our recent portfolio rebalance, we began taking steps to take advantage of the higher available yields, adding funds to both high yield and laddered bond strategies.
From a broader perspective, the U.S. economy continues to exhibit several strengths, certain weaknesses, and an overall cloudy outlook. On the plus side corporate earnings have held up so far, and while stock valuations and P/E’s have declined, there continues to be a LOT OF CASH on corporate balance sheets that could help them weather economic weakness, (although many companies have offered tepid or no guidance on their future revenue or earnings). Weekly railroad shipments were surprisingly consistent all year, while automotive sales were down, reflecting challenges in a major durable goods sector. The very strong dollar demonstrates global economies believe in the U.S. economy, although it makes U.S. exports more costly to foreign buyers. Importantly, consumers continue to be in good shape, although the bloom is off the rose of many portions of the real estate / housing sector; existing home sales have edged slower for 7 straight months, albeit from a breakneck pace in recent years.
What to make of all of this? For more than three decades we have witnessed a consistent phenomenon: As soon as everyone knows what is about to happen (of course we are having a recession, right?) markets ofien challenge that perspective by performing in a way that proves most people wrong. Yes, we could have a “regular” recession in the next year or two, and Fed tightening to the level they have committed to thus far, almost ensures that. However, we have never had a recession without a meaningful rise in unemployment, and none of these outcomes are guaranteed. It is also possible that we could just have a mild sofiening period of economic activity, whereby the economy absorbs higher interest rates and modestly lowers demand, followed a year or so later by a period of more normal growth. Either way, our job is to build durable investment portfolios to allow you to continue with a secure financial future, and we are striving to do just that. As always, we look forward to speaking with you at your convenience.