The Deep Value of Bonds

November 21, 2023

“Bond selection is primarily a negative art. It is a process of exclusion and rejection, rather than of search and acceptance.”

– Benjamin Graham

Intro

In the past few weeks, the bond market has been doing its best John Maynard Keynes impression, quoting, “When the facts change, I change my mind.”

One fact that changed was the October CPI report. Though just a slight beat to expectations, the report showed continued progress that pandemic inflation is moderating, including even the stickiest components like owners-equivalent rent. Yields fell sharply in response to the cooler inflation print, with further downward pressure coming from some slightly cooler economic data. Taking CPI and economic data together, bond traders quickly priced that the Fed would not be raising rates further this tightening cycle and will quickly pivot to rate cuts in 2024.

As we have written previously, the risk/reward for bonds has become more balanced for investors who can tolerate short-term losses to “lock in” elevated long-term yields at levels not seen in a decade and a half. Looking back, the starting point for fixed income returns is vastly better than in 2022, when rates were near generational lows, and the Fed was about to embark on a rate hiking cycle. In contrast, the current levels of interest rates, far higher than 2022, have a much better risk-reward, creating potential for positive returns in both rising and falling rate scenarios.

The bear market in bonds is nearly two years old, but recently there were a few tentative signs of an ending. The broad bond index, the Bloomberg Aggregate Bond Index, turned positive this week for the first time since the fall of 2022. The volatility of interest rates has also started to decline, as measured by the MOVE Index (similar to the VIX volatility index for equities.)

Chart 1

As of 11/21/23

For credit, spreads on investment-grade and high-yield bonds have narrowed by 40 to 60 basis points when the S&P 500 reached a bottom on October 27. With the Fed cautious about the rates outlook, the issuance of corporate bonds slowing down, and in general a risk-on tone returning to markets, liquidity returned to investment grade and high yield, which helped lower yields and narrow spreads.

Further helping to stabilize the interest rate environment has been the outlook for and reception of increased Treasury supply. Some volatility has persisted around some of the Treasury auctions, but the worst-case scenario of an unwelcome flood of Treasury issuance has been avoided for now. 

Against that backdrop, investors can evaluate what could outperform and underperform in an environment where inflation continues to moderate, the economy remains relatively resilient, and the Federal Reserve’s benchmark rate gradually normalizes. The shorter maturity, floating rate fixed-income is likely to lag in a rate-cutting cycle, whereas longer maturity, higher interest-sensitive bonds can outperform.

We must note that this ultimate soft-landing scenario of low inflation, resilient growth, and easier Fed is certainly not guaranteed or may not be sustained for long. First, given the backdrop of moderating yet still-elevated inflation, the Fed may not deliver on the easing that is already priced in by the market. Second, we are monitoring developments in the labor market closely, noting signs of initial easing that could evolve into broader or deeper weakness. In this scenario, Fed easing is more likely, but it would come with weaker growth and more economic challenges. Both of these scenarios could result in different performance leadership within the bond market.

Below, we look at how Mortgage-Backed Securities, Preferreds, and Emerging Market bonds, all areas of distinct weakness and “deep value” within the bond market in recent years, could perform in a falling rate and lower volatility environment. Investors should be aware of the dynamics around these asset types, as they are common holdings in many active and diversified bond strategies.

Deep Value

The bond market could be compared to the analogy of a supermarket. There are a lot of choices and alternatives for investors. The way interest rates fluctuate, and change dictates what performs and what does not. In a bond market where the Fed is on hold and the economy is mixed, yields could be going sideways to lower and that is conducive to lower interest rate volatility.

An asset class that is highly sensitive to lower rates and lower volatility is mortgage-backed securities (MBS). The securities have an embedded call option to prepay the underlying mortgages because as rates fall, mortgage borrowers will often choose to refinance at lower rates. This feature makes these bonds particularly sensitive to a change in interest rates when they are starting from an elevated level, a dynamic known as “convexity.” It is a feature specific to MBS where the duration of the securities adversely extends when rates go up.

When yields rise substantially, as they did over the past two years, the prepayments of mortgages slow down. That makes MBS subject to convexity, which accelerates their decline in value. Importantly, when yields reverse lower, and volatility goes down, MBS can outperform.

This is the case when the MOVE Index, which is a composite of interest volatility and inversely related to the MBS ETF, MBB, starts to decline, as shown in chart 1. The yield on MBS is around 5.5%, which is 100 basis points over US Treasuries.

Chart 2

Source: MacroBond, as of 11/21/23

Within fixed income, there are alternative ways to express the idea of a bond, such as “preferreds”, which are hybrid versions of fixed-income securities. They pay a regular, fixed, or floating rate coupon and have call features but not a final maturity. The securities are a preferred stock or issued as perpetual bonds that have no final maturity.

Preferreds are issued mainly by large banks and regional banks, which in recent years have accumulated large holdings of Treasury bonds. The significant balance sheet holdings of Treasuries has been one driver of the rising correlation between preferreds and Treasuries, mostly because Treasury yields have risen and unrealized bond losses have swelled on bank balance sheets.

As a result, the PFF ETF has lagged behind the S&P 500 by a wide margin since the crisis of Silicon Valley Bank (SVB) in March. Yields on preferreds have reached an average of 9% versus the average dividend of the S&P at 1.5% and the KBW Regional Bank Index at 4%.

Chart 3

Source: MacroBond, as of 11/21/23

If US interest rates continue to decline and further rate cuts are priced in, the dollar could weaken against other major currencies. Historically, a weak dollar has propelled the value of emerging markets (“EM”) and international fixed income.

While the performance of EM equities has been mixed, there is stronger evidence of positive EM fixed-income performance in weaker dollar episodes. Conversely, when the dollar strengthens, EM equities and bonds underperform.

Emerging market bonds have higher yields of 6% to 8% as central banks raised rates by double that of the Federal Reserve. While the dollar could depreciate on lower US rates, it also depends on the performance of the US economy. EM bonds have longer maturities and higher durations, which makes them benefit in falling interest rate environments. 

Chart 4

Source: Macrobond, Bloomberg, as of 11/21/23

Conclusion

Bonds seem to be finding their footing, although we caution that there are still risks associated with extending duration far out of the yield curve. The risks of large fiscal deficits, a “head-fake” in inflation (inflation beginning to rise again), and political uncertainty (mostly in an election year) remain. But yields are showing a sign of stabilization that is bringing volatility down, shining a light on “deep value” areas of the bond market such as mortgage-backed securities, preferreds, and international fixed-income. Though these asset types may be too esoteric or volatile for many investors to hold as a stand-alone through cycles, many bond managers who run diversified and active strategies maintain positions in these assets, making it important that investors are aware of how these asset types could behave in potential interest rate environments.

IMPORTANT DISCLOSURES

Abbreviations/Definitions: Mortgage-Backed Security (MBS): an investment similar to a bond that is made up of a bundle of home loans bought from the banks that issued them. Investors in MBS receive periodic payments similar to bond coupon payments; PFF ETF: the iShares Preferred and Income Securities ETF seeks to track the investment results of an index composed of U.S. dollar-denominated preferred and hybrid securities.

Index Information: All returns represent total return for stated period. S&P 500 is a total return index that reflects both changes in the prices of stocks in the S&P 500 Index as well as the reinvestment of the dividend income from its underlying stocks. Dow Jones Industrial Average (DJ Industrial Average) is a price-weighted average of 30 actively traded blue-chip stocks trading New York Stock Exchange and Nasdaq. The NASDAQ Composite Index measures all NASDAQ domestic and international based common type stocks listed on the Nasdaq Stock Market. Russell 2000 is an index that measures the performance of the small-cap segment of the U.S. equity universe. MSCI International Developed measures equity market performance of large, developed markets not including the U.S. MSCI Emerging Markets (MSCI Emerging Mkts) measures equity market performance of emerging markets. Russell 1000 Growth Index measures the performance of the large- cap growth segment of the US equity universe. It includes those Russell 1000 companies with relatively higher price-to-book ratios, higher I/B/E/S forecast medium term (2 year) growth and higher sales per share historical growth (5 years).  The Russell 1000 Value Index measures the performance of the large cap value segment of the US equity universe. It includes those Russell 1000 companies with relatively lower price-to-book ratios, lower I/B/E/S forecast medium term (2 year) growth and lower sales per share historical growth (5 years). The BBB IG Spread is the Bloomberg Baa Corporate Index that measures the spread of BBB/Baa U.S. corporate bond yields over Treasuries.  The HY OAS is the High Yield Option Adjusted Spread index measuring the spread of high yield bonds over Treasuries.  KBW Nasdaq Regional Bank Index is a modified market capitalization weighted index designed to track the performance of leading banks and thrifts that are publicly traded in the U.S that includes banking stocks representing large U.S. national money centers, regional banks and thrift institutions. The Bloomberg Aggregate Bond Index includes government Treasury securities, corporate bonds, mortgage-backed securities (MBS), asset-backed securities (ABS), and munis to simulate the universe of bonds in the market. It tracks bonds that are of investment-grade quality or better. ICE BofA MOVE Index is calculated from options prices, which reflect the collective expectations of market participants about future volatility. The index measures the implied volatility of U.S. Treasury options across various maturities.

Sector Returns: Sectors are based on the GICS methodology. Returns are cumulative total return for stated period, including reinvestment of dividends.

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