In this episode of Markets in Focus

Bonds are once again asserting their role as a store of value, portfolio diversifier, and income generator. James Camp, CFA, Managing Director of Fixed Income and Strategic Income at Eagle Asset Management, and Burton Mulford, CFA, Portfolio Manager overseeing all of Eagle's municipal strategies, delve into the likely course of monetary policy, its economic impact, and the implications for investors.

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Transcript

Matt Orton:
Quite a lot has changed over the last year. We've gone through one of the most rapid monetary tightening cycles on record, which understandably led to a very painful year in 2022 for both stocks and bonds. And a lot of the speculative froth in equities has been blown away. Think SPACs, ARK Innovation, other high-duration assets like that. But one other key change that has occurred is that, for the first time in over a decade, investors no longer have to reach down the credit spectrum and take on additional risk in order to get a respectable yield. It was a very painful process to get to this point, and I think the $1 million dollar question many of us are asking right now is where do we go from here?

This is Markets in Focus from Raymond James Investment Management. I'm your host, Matt Orton, and I invite you to join me and my colleagues as we discuss the latest trends and developments driving the markets. Visit us at Markets in Focus podcasts.com for additional episodes and insights.

The market and the Fed are finally starting to converge with respect to the terminal rate and the idea that higher for longer actually means just that. As the debate about the economic outcome continues, whether it's a hard landing, a soft landing, or no landing, it's easy to look at the very attractive yields on money market funds and short-term Treasuries and just decide to hide out. I mean, after last year, why not?

But there are better ways to position yourself where you can still capture a compelling yield while also balancing risks and opportunity costs. And it all comes down to asset allocation. This worrying discussion really needs to be dove into much deeper and to help us do that today, I've brought back James Camp, Managing Director of Fixed Income and Strategic Income at Eagle Asset Management, as well as Burton Mulford, Portfolio Manager and Trader for Eagle Asset Management's Tax Advantaged portfolios. So James and Burt, thanks so much for joining me today.

James Camp:
Pleasure to be with you, Matt.

Burton Mulford:
Very good.

Matt Orton:
So let's just dive right in. We've seen periods in the past where investors have had run to these shorter-term Treasuries and money market funds to lock in a higher yield, but these periods don't last for too long and these investments aren't truly riskless. So James, maybe you can comment on some of the risks that investors don't often consider.

James Camp:
Yeah, Matt, thank you for the question. This is the first time in multiple decades that we've had to confront the idea of purchasing power protection for investors. And what we see with investors typically is they'll look at the yield number and they'll be attracted to the highest yield. But what we know about short-term yields is they're very fluid. As you mentioned, over the past 12 months, we've been in this aggressive rate tightening cycle, in fact, one of the most aggressive on records. But we also know that as the economy moderates, perhaps slows soft, hard, whatever landing, that the Federal Reserve and short-term rates will not be here two years from now. So implicitly in buying short-dated instruments is an idea that that instrument will be reinvested. Now to be sure, if a client has cash and a cash equivalent as an asset class in their asset allocation, these are very generous cash yields. If the client has a need for long-term income and fixed income diversification, short-term instruments will not do that.

So what we've seen is the 10-year Treasury go from 40 basis points at the peak trough, depending upon how you look at it during COVID, to almost 4%. That is an historic move in intermediate and long-term yields. Those yields, relative to history and, in fact, relative to any other income-producing asset, think dividend stocks or other income surrogates, are actually very generous. You couple that with the fact that corporate bond spreads are additive to that Treasury yield, and you are getting to the point with intermediate and longer-term taxable bonds where you're earning an actuarial return that fits a retirement or long-term goal.

So reinvestment risk is key. Purchasing power protection is key as is the recognition that yes, this has been an aggressive Fed tightening cycle, but ultimately inflation will moderate, will slow, and ultimately the Federal Reserve will not be at these overly restrictive rates two years from now.

Matt Orton:
Yeah, I think that's a great point, this too shall pass. And I think one other item to maybe go into is the idea of opportunity costs. What comes to mind immediately is municipal bonds as well, after a really rough stretch last year, we finally saw a turn and some really good outperformance from munis starting in November. And I think municipal bonds in 2023 so far have posted their second-best start to a year in over 30 years.

So, Burt, maybe it's a great time to get some color on the rally we've seen lately. And do you think it can continue for those that might want to come off the sidelines or who are sitting in their four or four and a half, 5% short-term Treasuries? Is there still value?

Burton Mulford:
Sure. Well, thank you very much, Matt. Yeah, to put things into perspective, as of October 31st of last year, the high-grade benchmarks, the Bloomberg seven-year was down 9.6% and the 15-year was down 14.5%. The next two months we saw a significant rally. The seven-year closed at down 5.9%, so it rallied about 370 basis points of performance. And then the 15-year closed down 9.4%, so that rallied 510 basis points. So we saw a significant reawakening in the relative value for the muni asset class.

January was very strong. Seasonally, January is strong in the muni market because you have a lot of bonds that mature on January 1st, so that redemption period is very high. That money's got to find a home. So there was a chase for bonds and, coupled with the lack of new issuance, the deals were not prolific. So the performance for January was very strong, as you mentioned, two and a half percent and up 3% for those two benchmarks.

February, we saw some softening, and right now in March we're kind of in a wait and see attitude because there's a lot of uncertainty with respect to inflation and the impact with what the Fed's going to do on muni relative value.

Matt Orton:
So putting that all together then, if people are looking to get back into the market, would you say they've missed an opportunity or do you think there's still relative value for people who want to continue to allocate to the space?

Burton Mulford:
There is significant seasonality in our market. March historically is the worst-performing month for munis, and a lot of that is tied to tax season. Going into April 15th, there's typically selling pressure from retail investors to pay tax bills. Why munis and not other asset classes? Munis are not used in qualified plans, so there's a tax incentive and a taxable account to generate some sales to pay taxes and do some tax loss or restructuring. So we think right now is a good time to put money to work because the new issue calendar is really accelerated and ramped up. So the forward calendar from munis has almost doubled in terms of size. So I think now is a good time to at least consider putting money to work.

Matt Orton:
Yeah, that's great. And I think along the same lines, to bring James back in, thinking of the massive moves we've just seen this year with respect to the market aligning itself to more of where the Fed is going to go and what higher for longer means, what would you say, James, to someone who doesn't think that the selloff in bonds is done, that there's still more room to the downside? I mean, after all, two-year yields are still within, I mean we passed the November 22 highs, could be pushing five-plus percent. What would you say to an investor who thinks that?

James Camp:
Matt, to the point of is it done? I would agree with the hypothetical. I think the Federal Reserve is going to continue to raise short-term rates. I think the summer months we're going to get into some relatively easy comps on inflation. So at least the headline data is going to stay high for a while. And what we would say about the 10-year Treasury is it's likely to move marginally higher from here. We do think it will end the year lower as we begin to see the reality of economic slowdown, perhaps recession in the back half.

But the most important thing we can tell folks is there’s absolutely nothing wrong with using some of the short-end yield and the generosity of the short-term yields as well as the memory. I mean 2022 was difficult, so to bring clients back into the market, things like barbelling, to put some money to work in the short end to get some yield there, to get some safety there, but not to let these opportunities, intermediate/long-term assets, go for the begging when we'll wake up a couple of years from now and wish we'd locked some of that up.

And we know particularly in moments of transition, and this is decidedly a moment of transition, from deflation to inflation, low rates to higher rates, the idea of dollar-cost averaging is evergreen but particularly important at this point in time. So if a client has, let's just say, the ability to fund a bond account, it is either through direction on the advisor to DCA, which we can certainly do or it's at the advisor's execution to have some short-term assets and then open a bond account. That seems very reasonable in this particular time.

The other thing I will tell you, to dovetail a bit on my colleague Burt Mulford's comment, is using the SMA platform or individual bonds in whatever form however they are presented to you, is incredibly important at this particular moment. The fund complex is moving in fits and starts with these volatilities. NAVs (net asset values) are fluctuating in kind with that, and we think this is really the period where individual assets are going to shine. They will continue to do well, we believe, relative to more passive vehicles.

And then I would also say, in terms of bond allocation, 2022 was difficult for correlations. We had a massive move in short rates. We had a regime shift, correlations moved positive. Bonds will return at these yields and these valuations to their rightful place as a diversifier. Cash investments are not diversifiers and that's important to remember.

Matt Orton:
That's a great segue to what I want to touch on next, which is the idea of asset allocation. To what you were saying, sure, you can hang out and cash your money market funds, but it's not a true asset allocation and you can probably get a similar yield through a more thoughtful asset allocation approach and also have the opportunity for capital appreciation as well.

So, James, this I know is your area of expertise. How are you approaching asset allocation right now both within fixed income and also within fixed income and equities more broadly?

James Camp:
Great question, Matt. First and foremost, the inflection point has occurred where bonds are now out-yielding stocks. For a while, that was not the case over the past decade. From an asset allocation perspective, we are near-term cautious on rates. That is because, as you mentioned in the beginning, inflation is more menacing, there's more inertia behind it. The Fed has much more work to do. There's vulnerability on the short end of the curve and a little vulnerability on the long end, at least for the next quarter or so.

The other side of that equation, as I mentioned at the top, is purchasing power protection and the fact that inflation is unlikely to go back to a long-term trend of 2% any time soon. For investors and advisors to keep clients whole from a wealth and purchasing power perspective, there's going to have to be some compounding of income. And compounding of income usually takes the place in our portfolios of dividend and dividend-paying stocks which continue to grow, continue to pay, and continue to compound.

At the moment we have a reasonably high allocation to cash and cash equivalents because there's limited yield give-up to do that. We are still, we believe, in a let's see what the economic slowdown really looks like. We are firmly in the belief that we will have one. More importantly, we're of the belief that margin compression, that earnings will be challenged at least in some sectors over the next couple of quarters. But from an asset allocation perspective: kind of benchmark-type weight in equity and equity income-type product, marginally underweight in pure fixed income, and a slight overweight to near-term cash and cash equivalent assets.

Matt Orton:
And I think one other important point is that an asset allocation doesn't mean it needs to be static. We can argue 60-40 portfolio and how that works, but what I would argue has died is the idea that you can just leave an allocation and be done. So maybe, James, you can also talk just a little bit about the importance of being tactical within an asset allocation and how you think about making the appropriate moves as data continues to come in.

James Camp:
Yeah, Matt, as you know, we have a very robust set of screens and tools that we use to make asset allocation decisions in our multi-asset class income strategy. But the most important of which is really the judgment of the team, both the equity team and the bond team meeting collaboratively bimonthly to talk about the interaction in the capital markets between debt and equity. And we know post-2008 that those interactions between debt and equity and capital structures are very, very important to the health of companies, to the dividend-paying power of companies and to the relationship between income in different parts of the balance sheet. It's really been the art of asset allocation within the income space. In the asset allocation and strategic income, for example, we're seeing relatively dear corporate bond spreads and relatively robust earnings in the equities that we own and the compounding of the dividends.

So as spreads have tightened even in the face of Fed tightening, we have shedded a little bit of the corporate exposure in favor of the equity side, which continues to pay in compound. As we move closer to an economic slowdown towards the beginning of the end of the Fed cycle, which we think probably happens sometime this summer, if we get a commensurate widening of corporate bond spreads, meaning they go to more longer-term or even higher spreads relative to history, we are going to be much more productive on corporate credit. And I assume, Burt, the same would hold for municipals as well in our multi-asset class income strategies. As municipals get cheaper, if you will, we'll allocate more heavily towards those relative to stocks.

Burton Mulford:
Yeah, I would absolutely agree. Right now, we have an overweight to clean, very high-grade, predictable cash-flow types of credits. So we've got a lot more AA and AAAs than we do single-A and I think that there's going to be continued pressure in certain sectors in our market, particularly hospitals that are under pressure because there's some changes going on post the pandemic and then a lot of contract workers putting margin pressure on that sector.

And then also an interesting part of the market that's relatively small is subject to AMT (alternative minimum tax). The AMT bonds are offering some attractive yield components, but you had mentioned a barbell earlier, we believe that it makes sense right now based on valuations in the yield curve in munis, now barbell structure makes sense because one-year AAA rated munis are yielding about a 3.20. The taxable equivalent yield on that is superior to a T-Bill is about a 5.30. And then we are combining that with longer intermediates, 15- to 20-year munis that are yielding greater than 3.25. So that belly of the yield curve for munis is relatively rich and we're avoiding that part of the market.

Matt Orton:
Yeah, and maybe even building on that, too. You mentioned supply and demand earlier in the conversation and we've talked a little bit about the different landing scenarios. Pick your adjective. I guess how would you assess the impact to the muni market depending on the type of landing that we ultimately have, and then also how will supply and demand dynamics impact your market?

Burton Mulford:
So we watch the demand side of that equation pretty closely. On a weekly basis, we're looking at flows in and out of our market on a muni fund basis, and it's been somewhat mixed. Last year was significantly negative, but we're starting to see some retail appetite on the demand side, but I still think there is a wait and see attitude that retail investors have got with regard to the Fed.

On the supply side, we've been expecting a ramp-up in supply with infrastructure being talked about. However, issuers are hesitant, I think, to come to market. The first two months of the year, issuance was down about 15% compared to the previous year. This month we're expecting a decent jump. So I think that would create a buying opportunity once supply starts to ramp up. So this week and next week, there's some relatively large deals, which is going to create some opportunity.

Matt Orton:
And one last question. Why do you think it is that there is some hesitancy? Because you hear so much about municipalities being flush with cash after COVID and growing tax spaces. What do you think drives some of that hesitancy to issue new bonds?

Burton Mulford:
I think the debt ceiling talk kind of scares some issuers, the volatility that would be implied with that. And then also I think that issuers, since they are flush in cash, there's not a lot of incentive to go out and raise a lot more capital at this point. And then in the past, refunding deals or refinancing deals, were making up about 50% of all issuance. Now, the refunding map doesn't make as much sense because if you could have refunded, you probably already have. So the deals that are coming to market today are for new-money projects.

Matt Orton:
It makes a lot of sense and I think that's a good segue to just think about the economy a little bit more broadly speaking. And I think what strikes me a lot is kind of the disconnects we have right now between survey data that I think has been painting a pretty volatile picture, maybe a little bit more of a negative picture, versus the hard data that still continues to hold up remarkably well. And, James, maybe you can highlight some of the biggest risks that you see right now on the economic front.

James Camp:
Well, Matt, you hit the nail on the head. The economy continues along. It is rotating, however. We're seeing the stay-at-home bubble kind of burst. We're seeing people out and about moving: hospitality, travel, those sorts of things. The pent-up demand for that continues and people are consuming at really pretty astonishing rates given where I think we are in the cycle. How long that last is perhaps anybody's guess, but I suspect it slows and perhaps slows relatively materially.

I think the biggest risks to the economy are: one, the labor market not being fully engaged and the difficulty and the tightness of the labor market continuing to put pressure on corporate margins and earnings, if you will. And I think the other thing that is perhaps more underneath the surface is let's just remind ourselves that we went from a market with pretty much free capital, free money, for a very long period of time to a highly restrictive and getting more restrictive policy. The LIBOR rate, the SOFR rate, those types of things are approaching 5%.

We know that in a quest for yield, there was a massive uptick in private debt, in private equity, and things like that that are more opaque. And we know a lot of these products and things are highly levered. The cost of leverage has gone up materially. Is there something in those markets, those more opaque markets, that can be disruptive to the system going forward? Maybe not the base case, but something that I certainly watch very, very carefully and I think reaffirms my belief that public transparency, public markets, well-executed separate-account individual assets, that level of transparency, particularly in volatile markets, is absolutely key to investor peace of mind and, in fact, I think investor experience and performance.

Matt Orton:
No, it's a great point. And I guess the flip side to that that people are maybe finally starting to ask now is what could go right. You look at the economy. What could happen that allows us to navigate a soft or soft-ish landing? Why might this time be different?

James Camp:
Well, I think the Fed can do it. I think the Fed can get inflation under control. I don't think it's a permanent condition that we are going to be in a five, 6% inflation environment. I don't think we're going to go back to a 2%, but if we think about economic history and financial market history, the Fed could begin relaxing the tightness some time maybe early next year if there is a recession. We could get a positively sloped yield curve. We could get some level of base inflation which, by the way, we've been trying to do for a couple of decades. This was sort of the objective.

So I think the economic scenario is we are redeploying capital more efficiently. The free money era is over and companies and investors return capital to their proper allocations, if you will. That means companies spend on R&D. They spend on capex. They spend on automation. All of those things are productive, that we simply have a market where you can use, sort of facetiously, the SPY ETF as your index, as your money market fund. Those days are over. The capital markets now look more normal. They look more balanced. And I think capital allocation and economic wealth creation is served by a more normal macroeconomic, more normal fiscal and more normal monetary environment over the course of the next handful of years.

Matt Orton:
I think that's really well-said. And I know we're running out of time, so I want to get some final thoughts here really to convey to our listeners, what parts of the market are you most excited about right now? If you're sitting on the sideline, what is a good time to come off the sideline? What's still out there as an investor? So, Burt, maybe we can start with you on the muni side and then close with James.

Burton Mulford:
Yeah, we're still advocates of the high-grade, clean credits at this point. Particularly during an economic slowdown and a potential recession, I would not chase the risky sectors in high-yield. We have an underweight to healthcare and we currently are overweighting local GOs that are backed by property taxes or ad valorem taxes in states that are favorable demographically like Texas and Florida and Utah and the Carolinas, where you're seeing a migration out of high-tax states into more tax-friendly states.

So if you live in California and you want to own munis, I still would do a 100% California at this point to avoid that 13.3% state income tax. The governor is talking about adding a wealth tax out there, so there's that much more incentive. The Cal market trades richer at lower yields because of that demand, not necessarily because it's a stronger credit, but I think there's still opportunity in our market in a high-grade market. But I like the long end and I like the short end at this point.

Matt Orton:
Great. And James, final word.

James Camp:
I would simply say bonds are back. Their rightful place as a store of value, diversifier, and income generator has been reestablished and it's been reestablished in a very quick fashion. And despite the pain of 2022, mathematically speaking and practically speaking, that rip the Band-Aid off approach that the Fed and the markets have had is actually going to be productive.

So I'm most excited about the fact that fundamentals are going to matter again, asset allocation, all the things that are evergreen and in the DNA of our firm, and I think of our firm proper, now are more balanced and it's sort of back to really more normal macroeconomic and capital flows. And that to me absolutely should be encouraging to every one of our listeners. It certainly is to me and my team.

Matt Orton:
No, that is perfect. You heard it, everyone. Bonds are back. Asset allocation matters again.

But thank you so much, James. Thank you, Burt, for your time today. This has been a great discussion. Thank you to all of our listeners and, until next time, take care.

Thanks for listening to Markets in Focus from Raymond James Investment Management. You can find additional episodes and market insights at Markets in Focus podcast.com. You can also subscribe to our podcast on Apple Podcasts, Spotify or your favorite podcast app. Until next time, I'm Matt Orton.