After an Empty First Half, Where Should Income Thirsty Investors Look?

Jeffrey Addis:
Welcome to our podcast. My name is Jeffrey Addis. I’m the Chief operating Officer of Merganser Capital Management. Before we begin a few important regulatory disclosures. This presentation is for informational purposes only and should not be considered as an investment advice or a recommendation of any particular issuer, security strategy or investment product. Now on to our podcast.

Andy Smock:
Hello, this is Andy Smock, CIO of Merganser. I’m here with Todd Copenhaver. We’re going to talk a little bit about inflation, in particular what it means for fixed income as interest rates have reset and we look at the world through a new lens. The backdrop, the recent news there is that the most recent inflation report, which got a lot of news, was pretty positive. Depending on who you ask though or what news story you read, you might get different stories. It was flat or a little negative month over month, which is a big change from what we had seen, but the year over year number was still very high. The trend, if you look at the line of inflation month to month, was flattening out. It was actually a little bit negative. It was a good thing to happen, but it’s too early to celebrate when you’re still looking at year over year numbers that were at 40 year highs.

But relative to June, it was an incremental improvement. So what does the Fed do with that? We’re going to talk a little bit about the Fed rate increases, the balance sheet, and then our views of inflation, what Merganser’s doing about that, and then move on to short duration today and what the landscape looks like going forward. So Todd, my view is that the Fed, the market at least is pricing in about 100 beeps between the next two meetings September, November, it’s oscillating a little bit about which meeting takes which ones, whether it’s 50-50 or a 75 and a 25. And in my mind it doesn’t matter too much. Do you agree with that?

Todd Copenhaver:
I think that’s a fair characterization and I think largely symbolic in terms of the when of those hikes. It’s more the cumulative level that’s going to be more important. I think the timing between 25 basis points in September versus November is maybe a bit more false precision than is really important. I think the really important takeaway is the Fed remains committed to pulling forward a lot of their activity to early and mid 2022 in order to give themselves some time to figure out where the economy is in early 2023 before assessing where they might be changing direction.

Andy Smock:
So fed funds today is at 250, another 100 would take it to 350 by year end. Now looking at next year, interestingly, the market’s thinking another 50 beeps for the first half of 2023 and then cuts. My feeling is that they would rather not add that extra 50 in the first half of 2023. They’d rather get to where we are, good resting place by the end of this year and then wait and see instead of raising 50 and cutting 50.

Todd Copenhaver:
I think that’s a fair characterization of what the typical experienced behavior of the Fed is. I don’t think it is a comfortable position for them to increase rates and immediately cut rates. I think that tends to reduce the credibility of the Fed and make market participants a little uneasy, which by extension makes the economy a little bit more uneasy. For them I think the Goldilocks scenario would be getting to an above neutral rate in the three and a half context and then seeing how the lagging effects start to play out rather than just those that are more real time in nature. Because there are significant parts of the economy that don’t show up in a month to month series and have some time in order to internalize what’s going on with funding conditions.

Andy Smock:
And they still have the balance sheet as well. Once they feel like they’ve done what they needed to do or can do in the Fed funds rate, I believe that they want to remain with just a treasury balance sheet ultimately, but they’re in no rush to get there. Right now, the Fed funds rate is only helping a little bit. They can only fix the parts of inflation that they can fix, not the major drivers. The balance sheets even further away from that, selling mortgages right now would hurt mortgage yields.
Ultimately what you can get, your mortgage rate that you can get and it would incrementally hurt housing. Housing seems to be slowing on its own. They don’t need to take extra action to slow that. So my view is that they are hesitant to sell mortgages at least in the next six to 12 months, but they will if they have to and they have to when they can no longer raise rates for fear of pushing the economy into a deeper recession, but they need to signal they’re not out of ammo and they still want to do more, then at that point I do think that they will sell mortgages. Do you agree with that?

Todd Copenhaver:
Yeah. I think housing is one a on the list of lagging components that are responding to rates. In terms of the actual housing activity, if you think about the life cycle of say a new home purchase, that’s not an instantaneous transaction that takes many months and many months beyond that to be fully internalized by the indices of price and housing activity. So for the Fed to after just a few months of very aggressive rate hikes be taking the temperature on that market that’s still producing the data, that’ll show where that’s going. Seems a bit premature and I think they would agree with that. I agree that they’re not looking forward to holding mortgage paper indefinitely, and that is something that they do actively want to exit. But I also think that they are cognizant of just how detrimental it would be to have a housing crash commensurate with high inflation.

And to have that as a add-on to a tightening down the road if they saw above expected resilience from that market, I think makes some sense. So on balance, I think that the mortgage component of the balance sheet is likely to remain at least for the next six to 12 months. You might start to see some signaling of outright selling down the road, but they don’t have to do anything more than they’re already doing to see that decline. And I think they’ll be pretty quick to point to that if they are given pushback on that to say, “Hey, we’re not reinvesting.” And that in and of itself is a decline in that balance sheet figure.

Andy Smock:
So here we are, Todd. It’s mid-August. Yields have come up tremendously and I think we can say the glass was half empty for fixed income returns for the first half of the year.

Todd Copenhaver:
I would say that they were fully empty.

Andy Smock:
They were fully empty. Okay. But on the other side of that is that yields are relatively high right now. We’ve seen inflation prints, we’ve seen the Fed move and all those factors have pushed the two year yield to be just about the high point on the entire yield curve periodically that the 20 year has fought for that title. But aside from that, every other point of the curve is meaningfully lower. There’s negative slopes, 2s-10s and 2s-30s. One of our client bases that are most sensitive to quarterly total returns is short term bond clients. And you and Salone have done some work on modeling a market neutral view of what the future might look like. Can you tell me about that?

Todd Copenhaver:
Coming into 2022, we anticipated this to be a pretty unique time period for particularly short duration fixed income investors. As the Fed was coming out of a period of being accommodative in response to an exogenous shock to the market that was likely to be a bit more, for lack of a better term, transitory in the form of a pandemic. And to be coming out of that, they were likely to be aggressive in returning to a neutral rate as the effects of the pandemic quickly dissipated as we saw consumer activity do. Now we wanted to take a market neutral view where it wasn’t about what we thought the path was going to be. We like to underwrite to a wide range of outcomes when we’re thinking about investing over the long term. And one of the ways to do that is to not only incorporate your own views, but just something that there’s more market based that gives you a sense of what’s currently priced in.

And over the course of this year, we’ve been consistently revising and updating what the market expectations have looked like for short duration fixed income, to have a view towards what the future holds as income increases, as the benefits of those yields begin to work their way through portfolios. And what that’s going to do for income potential, particularly on the short end where income is over the long term, the dominant force of returns. Year to date, we’ve seen nearly 2.5% drop in the one to three gov credit, which is the typical short duration index that puts it as one of the worst first halfs ever in the history of fixed income. And on the balance of the year however, because of that pull forward of the Fed’s activity to raise rates more quickly, not changing their terminal view that much, although it has been rerated higher, it’s really been the timing.

And so the back half of the year and into 2023, the market’s now expecting the benefit of that income to really come through in performance where you’re getting that higher yield, you’re clipping that bigger coupon. And so the year-end figure is in the market neutral model looking closer to down 170 basis points. So still negative. That quick move by the Fed is tough to fully offset given how low yield started the year. But then 2023, you’re looking at one of the higher annual returns that we’ve seen in the past decade. It would put it just shy of the return in 2019, which was a recent high at just over 4%. And then interestingly, it would put it in the context of the combined returns of 2015, 2016, 2017, and 2018 in terms of what that income is going to do to portfolios as you look forward.

It’s a powerful force and it’s really the driving interest in why folks invest in short duration fixed income in the first place is to be able to cook those coupons. And I think that that starts to dominate once you exit this period of essentially 0% front end interest rates. Now, it’s important to note that we’re taking a few assumptions into account here that are simplifying, one of which is the movement and spreads. We’re expecting spreads to be constant within the model. There isn’t a good metric that you can use for forward implied spreads. And additionally this is the index. So we’re not taking our own returns or the component of active management that we generally find to outperform passive management, particularly on the short end, given the technical dynamics there. But on balance, I think it’s a good reminder of income matters in fixed income and the quicker that you exit a 0% interest rate policy, the quicker you benefit from those higher yields while the path can be negative while you’re getting there.

Andy Smock:
And here we’re focusing a little bit more on short-term bond. Since short-term bond, clients tend to be more sensitive to quarterly negative total returns. Core clients tend to be asset liability matches or more broad asset allocators. But I will note that just looking as of yesterday for the short-term bond, one to three gov credit, the yield was 3.5, just a hair under that, and for core it was 3.6. So that’s for the AG itself, not for active management, but just looking at that, it’s very evident that kink in the yield curve that you’re getting a lot of yield in short-term bond. And it hasn’t been that case for a long time where core out yielded by a much greater margin historically than this. So to see those prospective returns come through like that is encouraging and it makes good sense given the empty first half.

Todd Copenhaver:
I think that’s an important point. And also illustrative of an important additional feature, fixed income particularly out the curve, which is the downside protection. So while the yields are a little bit higher for core, relatively modest higher, I do think that that additional downside protection that the ag provides, having that extra duration is something that is easily undersold during a period such as this, at least looking in the rearview. But looking forward, I think on balance, the Fed puts still exists in a world where inflation is under control. And to the extent that our one month trend turns into two, maybe three, et cetera, that the Fed will be back in play as one that will cut rates in response to a weaker economy.

Andy Smock:
So I think the bottom line from this podcast is that income really matters and for the first time in a long time, there is a lot of income in fixed income portfolios right now. And the point that Todd made, I think is an excellent one, that in addition to income, you get downside protection. So now for the first time in a long time you get both. We had experienced the downside protection and times of falling yields in the past, but we didn’t always have that income going into it, and we certainly didn’t have it afterwards. Any last thoughts, Todd?

Todd Copenhaver:
I think the thing to keep in mind as we go through the balance of 2022 is that timing and consistency of data. One of the things that I think market participants have a particularly hard time parsing is what’s a leading indicator? What’s a concurrent indicator? What’s a lagging indicator? And making sure that you’re internalizing those things with their proper timing consistency, if you will. And I think that there’s a lot to dig through in that, and this is one of the more challenging periods of digging through that as our investment philosophy dictates, we invest to a broad range of outcomes. And I think that in a world where you have all those inconsistencies and maybe the timing is variable, given how quickly things have moved, I think it’s really important to underwrite to the downside to make sure that you’re playing the role of fixed income and getting paid back at par over and over again.

Jeffrey Addis:
This commentary contained or incorporated by reference certain forward-looking statements, which are based on various assumptions, some of which are beyond our control. Opinions and estimates offered constitute our judgment and our subject to change without no as our statements of financial market trends, which are based on current market conditions. No part of this presentation may be reproduced in any form or referred to in any other publication without the express written permission of Merganser Capital Management. For more information, please visit our website at www.merganser.com. Thank you.