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Blogs

Bond market insights

Gary Pzegeo, CFA

December 02, 2021

From the desk of CIBC Private Wealth Head of Fixed Income Gary Pzegeo, CFA

Q: What’s your outlook on Fed action and raising of rates?

A: The Federal Reserve (Fed) has already begun a plan to reduce its monthly buying of Treasuries and mortgage-backed securities in response to stubbornly high inflation and improvement in the labor market. The Fed’s conditions for moving from “tapering” of asset purchases to actually increasing short-term interest rates include the achievement of maximum employment. Unemployment in the US could reach pre-COVID levels by the second half of 20221, which could lead the Fed to increase the Fed funds target. A low unemployment rate will be a meaningful step toward maximum employment, but the Fed is likely to consider labor force participation and wage growth as well.

Q: What expectations do you have for the bond market in 2022 and beyond?

A: High-quality bonds could face challenges in 2022 as the Fed moves off its zero target. The level of difficulty for bonds will depend on the persistence of inflation as the year progresses and the response required from the Fed. We expect bonds with exposure to credit risk will fare better in the near term, as economic growth supports corporate cash flow and municipal borrowers benefit from current fiscal programs and potentially higher tax rates. In general, fixed income faces the headwinds of high valuations we see across much of the capital markets after a long period of zero rate policy and narrowing risk premiums.

Q: What are the factors you’re watching to evaluate shifts in the bond market?

A: When it comes to bonds, we are constantly evaluating market yields against our outlooks for growth, inflation, and fiscal and monetary policy, among other factors. The current environment resists comparison to your typical business cycle. Today’s inflation is, in part, a residual of supply-side shutdowns and government-supported demand requiring a focus on a wide range of micro- and macroeconomic inputs. Pricing in commodities subject to supply chain disruption and employment growth in COVID-sensitive service sectors give us some insight on the permanence of various components of inflation. It has also been important to watch market-implied inflation expectations as a potential limiting factor on the Fed’s patience with accommodative policies.

Q: How do you balance the triple challenge of interest rates, duration and credit quality?

A: A bond’s yield contains a lot of information. Depending on the type of bond, the yield is the compensation for a wide variety of risks, including Fed policy, inflation, default, issuer calls and unexpected supply. We take a view on all of these risks and others in constructing a client’s portfolio. We currently see continued upside risk for interest rates and inflation within an overall positive environment for growth, leading us to:

  • Take less interest rate risk than the market in taxable bonds,
  • Emphasize inflation protection through the use of Treasury Inflation-Protected Securities in accounts holding taxable securities,
  • Overweight areas of credit risk in corporate and municipal bonds,
  • Position portfolios for further flattening of the yield curve,
  • Make use of noncore fixed income exposure with preferred stocks and leveraged loans.

Q: Given all the headwinds facing fixed income (rising rate, inflation, etc.), how should investors think about the risk management piece of their portfolio that has traditionally been the role of bonds?  Are there different strategies or asset classes, like currencies, that should be considered to help with risk management?

A: Core fixed income exposure in the US becomes a less effective hedge against equity market risk as yields approach zero and may become positively correlated with equities at times when stock market investors’ source of concern is bond yields. We currently recommend holding lower allocations in core bonds and have favored exposure to commodities, preferred stocks and floating rate loans over the last year as a way to reduce direct exposure to those headwinds.

 

Gary Pzegeo joined the firm in 2007 as head of fixed income, focusing on portfolio management, trading, policy formulation and client service.