- Bond yields are at their highest levels in years.
- This means that in the event of a recession they provide a downside risk.
- Scott Minerd, Ken Griffin, Michael Hartnett and Richard Saperstein are the bond fields.
The bond market looks set to spring for a breakout in 2023, with some of Wall Street’s biggest names calling it the final months of one of the worst years on record.
In an effort to stem the highest inflation rates since the early 1980s, the Federal Reserve has embarked on one of its most aggressive tightening crusades ever, implementing multiple interest rate hikes.
The result has been nothing but pain in stock and bond prices since the beginning of the year. The S&P 500 is down more than 22% since January, while the Bloomberg Aggregate Bond Index is down 16% since last November.
But bond yields, when bond prices are falling, have become significantly more attractive — at “levels we haven’t seen in forever,” Guggenheim Partners CIO Scott Minerd characterized them on a call with Insider last week — thanks to both. The Fed’s hawkish measures and the central bank trying to fight high inflation.
Here is this year’s US Treasury yield curve (in blue) compared to November 2021 and November 2020. Investors can earn more than 4% per year on the 10-year Treasury note. Last year this number was close to 1.5%.
“A Unique Win-Win Scenario”
This is one reason why high-yielding assets start to catch the eye of investors desperate for meaningful returns when assets decline.
Another reason is that during a recession, bond prices typically rise as investors pile into safe havens like Treasurys. Investors can then sell them at a profit.
As high as the yields are, bonds are a can’t-miss asset for investors, according to Richard Saperstein, CIO of Treasury Partners, which manages $9 trillion in assets.
“Bond investors are now facing an unprecedented win-win scenario,” Saperstein said in an October note. “Over the past 15 years, low interest rates have forced yield-hungry investors to double down on the riskiest stocks because of TINA (there is no alternative). Now that rates are up, investors can reallocate to bonds.”
He continued: “If inflation and rates continue to rise, bond prices will decline, but unrealized price losses can be significantly offset by locked-in 4-6% income yields. If the economy slows significantly, inflation will likely cool and interest rates will fall. .rates and higher bond prices.”
There is still debate among economists, Wall Street strategists and money managers about whether a recession will actually happen, but even those who don’t consider a downturn agree that the risks have risen significantly.
In fact, the US economy is showing signs of slowing, with job growth and consumer spending beginning to trend downward. However, unemployment remains low at 3.7%, and GDP was positive for the third quarter, after two negative quarters in a row.
But the Fed continues to press ahead with its tightening regime, signaling a willingness to inflict near-term economic damage to return price stability to consumers.
The very chart of the Treasury yield curve above seems to indicate that a recession is ahead. That’s because shorter-dated yields — like the 2-year note and the 3-month note — have risen above longer-dated yields, such as the 10-year note.
Yield curve inversions have preceded every recession since the 1950s.
Ken Griffin, founder of hedge fund Citadel, said in September that bonds can act as a portfolio hedge in the event of a recession.
“When 10-year bonds are at 75 basis points, or 1%, there’s no real upside to the bond at a time of recession that is often characterized by inflation,” Griffin said at CNBC’s Delivering Alpha Conference in New York. “But now that the 10-year bond is at 4%, if you go into a downturn and inflation goes back to the 1 handle, suddenly those bonds are worth quite a bit more than they are today.”
He added: “That’s a gain in your portfolio – that’s in the green, your stock portfolio is likely to be in the red.”
According to Griffin, the traditional 60/40 portfolio of 60% stocks and 40% bonds “looks a lot better today than at any point in recent memory.”
The ongoing turnaround in the bond market
Bonds in green and stocks in red is the scenario Michael Hartnett, chief global equity strategist at Bank of America, expects next year. He cited two and a half centuries of data.
“250 years of history says government bond yields will turn positive on the 23rd; recession = long bonds, short stocks,” Hartnett wrote to clients on Oct. 27. The exchequer has suffered losses for the second consecutive year, he said. and in 250 years they have never had three consecutive declines.
Hartnett said bonds are starting to “pivot” from a period of high yield and high inflation to a period of likely recession. Bank of America used the chart below to show that its customers are already moving into bonds.
Some are hesitant to get into bonds yet, believing yields need to rise further amid ongoing Fed efforts and questions about the validity of recession calls (if a recession doesn’t happen, Hartnett said cash will outperform bonds and stocks).
But according to Minerd, longer-term yields are unlikely to rise much further, as shown by the inverted yields on the 3-month note and the 10-year note.
His preferred view of bonds right now is to look at investment-grade corporate bonds. Investment grade corporate bonds are rated Baa by Moody’s and BBB by S&P and Fitch.
That’s because they offer a premium on risk-free Treasuries, and companies are unlikely to default on them in a recessionary situation, he said. Some believe that credit premiums over Treasurys will also rise during a recession because of the perceived higher risk, Minerd said, but premiums are higher more than 75% of the time, meaning the upside is limited.
“That’s a better place with your money than the stock market,” Minerd said.