by Brad Tank, Chief Investment Officer—Fixed Income, Neuberger Berman
Another week, another threshold for the U.S. 10-year yield. After racing through 1% at the start of the year, we were at 120 basis points by mid-February and touched 1.60% last Thursday.
This run-up in rates, on concerns about inflationary pressures as economies reopen and the stimulus flows, has been the topic of four of the last six CIO Weekly Perspectives and the talk of the markets.
Or rather, it’s been the talk of the equity markets. Perhaps surprisingly, it hasn’t really disturbed the peace among fixed income and credit investors. Is that likely to continue?
Duration, or sensitivity to changes in interest rates, is familiar territory in fixed income. It also started to turn up regularly in the equity investor’s lexicon last spring, however, as interest rates plummeted and growth stocks, which are theoretically the most sensitive to rates because their earnings are expected to be weighted further into the future, began to lead the market rebound.
For sure, some of that outperformance was due to technology growth companies capitalizing on the work-from-home environment, but for the first time outside of technical discussions, “long-duration equities” was a thing.
Once the relationship was established, however, it was always going to be likely to hold when rates started to race upward. Sure enough, growth stocks began to underperform value and cyclical stocks in December, and lose ground in absolute terms in February. And because a handful of mega-cap growth stocks have become so dominant, it has begun to look like the entire equity market is “long duration”—even though value and cyclical stocks have been performing well.
So why haven’t the same concerns been evident in credit markets? After all, they ought to be more obviously subject to duration.
It’s actually due to very similar dynamics as those at work in stock markets. Investment grade financial and corporate bond issuers are more likely to be value companies than growth companies, and high yield issuers are more likely to be cyclical. In an early-cycle environment, therefore, credit spreads can tighten enough to offset, or even overturn, the effect of rising rates.
Since the start of the fourth quarter of 2020, the U.S. 10-year yield has risen by more than 80 basis points while the spread of the ICE Bank of America U.S. Corporate BBB Index has tightened by more than 60 basis points, and that of the U.S. High Yield Index by almost 200 basis points, for a total return of almost 7%. Fund flows have continued to be positive despite the run-up in rates; investors appear confident in the credit story.
A Classic Early-Cycle Set-Up
We think there is limited scope for more of this dampening effect from spreads. But then again, we also think that the rising rates phenomenon might be close to burning itself out for now. We still anticipate higher but contained inflation during 2021, and while we caution that the risk is heavily skewed to the upside, we maintain our outlook for the U.S. 10-year yield to finish the year well inside of 2.00%. Our end-of-year target outlook is now 1.75%; should the sell-off in rates continue, we believe that level could provide a cap and the start of support from the Federal Reserve.
Our signature theme of income without duration has helped spare our credit portfolios some of the volatility at the very long end of the credit curve, in 30-year corporates and tax-exempt municipal bonds, for example, while benefitting from tighter spreads.
Within our credit portfolios, we have in recent weeks moved further from the parts of the market that are most sensitive to rising rates, such as municipal bonds and mortgage pass-through securities, and into global high yield credits that we believe have upgrade potential. That being the case, nonetheless we did use last Thursday’s sharp sell-off to reduce some of our short positioning in rates, while retaining what we consider to be a sufficiently defensive stance.
A more pronounced sell-off in those parts of the market could be a sign that inflation and rate concerns are taking hold. A reversal of fixed income and credit fund flows would also set off some alarms. For now, however, we continue to regard this as a classic early-cycle set-up, and positive for credit—making us more likely to edge back into longer-duration exposures on further weakness, rather than prepare for a sustained bear market in risk assets.
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