1. Income Dominates Total Return
Rationale: There are two primary components of a bond’s return: income and price appreciation. Following a hawkish Federal Reserve that set a path of aggressive interest rate hikes, we see the income component of a bond’s total return at its most attractive level since the depths of the COVID-led recession, but with far better fundamentals.
Components of Total Return by Sector: 2023 YTD
2. Bank on the Banks
Rationale: The US banking system has significantly bolstered its financial wherewithal since the Global Financial Crisis (“GFC”). Over a trillion dollars of capital has collectively been added to the banking system’s equity base since 2009, while accounting changes that took effect in 2020 have pushed banks to hold loan loss reserves to cover expected lifetime losses rather than just one year of losses.
Portfolio in Action: While we reduced our overall exposure to the banking sector through a reduction in regionals and certain hybrid capital positions, we remain confident in the largest money center banks. Concerns around commercial real estate, among other things, lead us to believe that stress in regional banking still exists. Therefore, our exposure is still biased towards G-SIBs (Globally Systematically Important Banks) which remain very well capitalized while maintaining strong liquidity profiles.
Mid-Year Status: MIXED BUT RECALIBRATE
The largest money center banks continue to be well capitalized but higher interest rates prompted concerns that growing unrealized asset losses on bank balance sheets could erode banks’ capital levels. This is particularly acute for smaller regional banks who have struggled to meet deposit outflows without raising liquidity from asset sales. Many of these regional banks still face further pressure from a weakening commercial real estate market that would directly impact their loan books. Meanwhile, larger money center banks have been net beneficiaries of deposits flows and we expect them to continue to reap the benefits from a much broader funding base and diversified business models.
3. Peak Volatility Behind US
Rationale: Periods of elevated bond market volatility typically create pockets of dislocation across certain segments of the market. One sector that has benefited from the recent rate volatility is Agency mortgage-backed securities. In the case of mortgage securities, we believed that a reduction in demand from the Federal Reserve as part of their quantitative tightening (“QT”) program would provide an attractive entry point.
Portfolio in Action: As interest rates have risen and mortgage spreads widened, we have been buyers of current coupon mortgages offering higher yields and good liquidity. Moreover, these securities will benefit from a meaningful decline in mortgage refinancing, slower new home sales and overall reduced housing turnover that has eased the supply of mortgage origination.
Mid-Year Status: MIXED
Mortgages suffered in 2022 due to multiple factors: 1) elevated rate volatility, 2) the disappearance of two large buyers, banks and the Federal Reserve, and 3) aggressive tightening of monetary policy that created an inversion of the US Treasury yield curve.
Mortgages have cheapened and technical pressure due to the persistence of higher volatility levels have kept them cheap.
4. Disinflationary Progress
Rationale: The full effects of Fed tightening, which always operate with long and variable lags, is now beginning to impact the broader economy. This suggests weaker aggregate demand in the second half of the year. In addition, labor supply and demand are moving into better balance, which should further reduce wage pressures going forward. Excess housing savings also continues to decline and point to a less resilient consumer going forward. And finally, last year’s moderation in rent increases is beginning to show through to reduced housing inflation as reported by the Bureau of Labor Statistics and the Bureau of Economic Analysis.
Portfolio in Action: We continue to maintain a longer duration bias in portfolios as we believe inflation will continue to drift lower as the Fed maintains restrictive policy rates. We believe the Fed will ultimately need to lower rates on the back of slower growth and falling inflation.
Mid-Year Status: ON TARGET
While inflation has proven to be stickier than anticipated, developments still point to lower inflation by year-end. However, a tight labor market and resilient economy have made the Fed’s job more difficult, and will remain so particularly if inflation expectations drift higher. However, we believe the Fed will be successful in reducing inflation and longer-term policy rates will re-normalize.
5. QT an Unknown Risk
Rationale: As the Federal Reserve seeks to reduce the size of its balance sheet in a process known as quantitative tightening (“QT”), a lack of liquidity will likely continue to weigh on the market’s ability to function normally.
Portfolio in Action: Improved overall liquidity profile of portfolios by increasing quality and rotating into US Treasuries and Agency MBS. We have also reduced exposure to lower rated debt, including high yield and emerging market debt, where applicable. Lastly, we have emphasized on-the-run issues relative to off-the-run.
Mid-Year Status: MONITORING
We continue to monitor whether quantitative tightening will impact bond market liquidity and overall market functioning. So far this year, liquidity metrics have remained relatively stable. Still, the coming wave of bill issuance following the debt ceiling resolution potentially presents a new risk to a healthy functioning market. To the extent increased bill issuance leads to a fall in bank reserves, banks will be pressured to reduce their securities holdings in order to maintain liquidity.
Source Information
“Bloomberg®”, “Bloomberg Indices®”, Bloomberg Fixed Income Indices, Bloomberg Equity Indices and all other Bloomberg indices referenced herein are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the indices (collectively, “Bloomberg”) and have been licensed for use for certain purposes by MacKay Shields LLC (“MacKay Shields”). Bloomberg is not affiliated with MacKay Shields, and Bloomberg does not approve, endorse, review, or recommend MacKay Shields or any products, funds or services described herein. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to MacKay Shields or any products, funds or services described herein.
COMPARISONS TO AN INDEX
Comparisons to a financial index are provided for illustrative purposes only. Comparisons to an index are subject to limitations because portfolio holdings, volatility and other portfolio characteristics may differ materially from the index. Unlike an index, individual portfolios are actively managed and may also include derivatives. There is no guarantee that any of the securities in an index are contained in any managed portfolio. The performance of an index may assume reinvestment of dividends and income, or follow other index-specific methodologies and criteria, but does not reflect the impact of fees, applicable taxes or trading costs which, unlike an index, may reduce the returns of a managed portfolio. Investors cannot invest in an index. Because of these differences, the performance of an index should not be relied upon as an accurate measure of comparison.
The following index may be referred to in this document:
Bloomberg U.S. Aggregate Bond Index
The Bloomberg U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. Must have at least one year to final maturity regardless of call features. Must have at least $300 million par amount outstanding. Must be rated investment-grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody's, S&P, Fitch. Must be dollar-denominated and non-convertible.
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This material contains the opinions of certain professionals at MacKay Shields but not necessarily those of MacKay Shields LLC. The opinions expressed herein are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and opinions contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Any forward-looking statements speak only as of the date they are made and MacKay Shields assumes no duty and does not undertake to update forward-looking statements. No part of this document may be reproduced in any form, or referred to in any other publication, without express written permission of MacKay Shields LLC. ©2023, MacKay Shields LLC. All Rights Reserved.
MacKay Shields LLC is a wholly owned subsidiary of New York Life Investment Management Holdings LLC, which is wholly owned by New York Life Insurance Company. "New York Life Investments" is both a service mark, and the common trade name of certain investment advisers affiliated with New York Life Insurance Company. Investments are not guaranteed by New York Life Insurance Company or New York Life Investments.
Information included herein should not be considered predicative of future transactions or commitments made by MacKay Shields LLC nor as an indication of current or future profitability. There is no assurance investment objectives will be met. Past performance is not indicative of future results.
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