Portfolio Intelligence podcast: fixed-income outlook for a potential monetary policy transition

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Current yield is the annual rate of return earned from dividends or interest of an investment. Current yield is expressed as a percentage of the price of a security, fund share, or principal investment.

An inverted yield curve occurs when short-term interest rates move higher than long-term rates as a result of deteriorating economic performance.

Interest-rate sensitivity is the measure of how sensitive the value of fixed-income investments is to changes in interest rates. Generally, the value of a fixed-income investment will decline as interest rates rise.

Duration measures the sensitivity of the price of bonds to a change in interest rates.

John Bryson:

Hello and welcome to the Portfolio Intelligence podcast. I'm your host, John Bryson, head of investment consulting here at John Hancock Investment Management. As always, the goal of this podcast is to help investment professionals deliver better outcomes for their clients and their practice.

Today I'm joined by Howard Greene and Jeff Given. Howard and Jeff are senior managing directors and co-heads of the U.S. Core and Core Plus fixed income team at Manulife Investment Management. Howard and Jeff and their team run over $50 billion globally as of March 31 2023, and combined they have over 70 years of investment experience.

Howard and Jeff, welcome.

Howard Greene:

Oh, thank you John. Happy to be here.

Jeff Given:

Thank you.

John Bryson:

All right, Howard, we're going to start with you. It's certainly been an eventful few weeks in the banking sector. Without getting into too many specifics around the companies, was there any common themes that you saw driving the volatility and any key lessons specifically for fixed-income investors?

Howard Greene:

Yes. I think the common theme was over the past year we've seen the most rapid degree of rate hikes from the Federal Reserve that we've seen the last five or six tightening cycles, we went from zero and now we're at a 4.75%, 5% funds rate. And the impact of that, usually it takes about a year for that monetary policy shift to have an impact. So here we are, a year later, we've gone from zero to close to 5% and all of a sudden, we're seeing a few cracks in the system. The Fed has broken something, a few banks have, I guess, bitten the dust, so to speak. But what this isn't is that it's not systemic. Each of these banks, we're not going to talk about them specifically, had their own internal issues that were unique to them.

The challenge is that the markets often throw out the baby with the bathwater. They act first, think second. And that wasn't the case here. Obviously, there was a lot of weakness and across the financial sector, broadly speaking across the banks, both U.S., European, what have you, but much less so amongst the major big six American banks, maybe perhaps a little more so in the more subordinated level of some of the US and European banks. But a lot of that weakness has bounced back, hasn't come all the way back, but I always use the often-used pebble in the pond analogy that the initial ripples are the greatest. And then as you know, the circles dissipate from the center, things calm down, the dust settles, and we go back on our way.

John Bryson:

So Jeff, Howard mentioned this rapid period of increasing rates and it looks like we may be near the end of that current tightening cycle. What does history suggest investors might expect as we enter these transitory periods between tightening and easing monetary policies?

Jeff Given:

Yeah, we are likely near the end of the hiking campaign. And looking back at prior hiking campaigns, you see a couple of different environments. One, you see a lot of stability at the end of the hiking campaign when you have inflation relatively stable, economic activity that has then skyrocketed, so the Federal Reserve does not need to necessarily bring it down a lot. The other periods of time when there's inflation is a bit more of an issue. It has created a bit more volatility, not necessarily in the interest rate markets, but in the riskier asset classes, equities, high yield and investment grade credit. And so that's one thing we need to keep an eye out going forward. And we do expect the interest rate volatility start to subside at some point in time when you have more certainty on what the Fed's going to do. But we do think that volatility can remain relatively elevated in some of the riskier asset classes as we start to transition.

One of the big uncertainties is how long is that transition going to be? And historically it's been anywhere from as short as six months to as long as a year and a half. So all eyes are going to be on the Fed. All eyes are going to be on inflation and the unemployment markets, we think for the next several months.

John Bryson:

So Howard, when you think about managing portfolios before this last call it 18-month window, the biggest challenge for a fixed-income investor for probably the last 15 years was finding decent yield, and certainly at a reasonable level of risk. That changed really quickly. It's not so much a challenge now to find that yield. How does that change yours and Jeff's approach to managing risks? And what do you think the investors going forward need to be thinking about?

Howard Greene:

Yeah, I mean, the first thing that I would mention is that our approach and our process do not change. We've been consistently running money the same way for the 20-plus years we've been doing it together. But given what's happened, it does guide us to how we position the portfolio for this point, this cycle. We're anticipating a slow normalization. The shape of the yield curve, it's been sharply inverted. It's less inverted now, and we think over time it begins to slowly move towards a more normal, positively sloped curve. For us, that means starting to position more with an intermediate maturities, but still being somewhat defensive on the credit side as we're very likely heading towards a slower economy. I think one of the biggest risks that investors have to watch out for now is just holding too much cash or too much really short-duration investments, right?

Jeff mentioned, you've mentioned, Fed's very near the end of the tightening cycle, which means the yield on cash is quite attractive relatively. It's higher than just what anything else you can do. But that yield can be fleeting and disappear very quick. When the Fed starts to ease, those yields will decline quickly. The investor's left reinvesting at much lower yields and there's no capital appreciation to show for it. Five- and 10-year treasury yields and the yield on our mutual funds that we run are near 15-year highs.

John Bryson:

Okay, very good. So one of the conversations on a lot of investors' minds is the chance of a recession, whether it be small or large. Jeff, I want to ask you, what's your view on a recession and generally how does fixed income perform against that type of economic slowdown?

Jeff Given:

Yeah, the risk of recession has increased quite a bit. We've gone through a near historic level of interest rate increases over a 12-month period, levels we haven't seen since in the pre-1980s. That does increase the risk that we have a recession going forward. I do think it's going to be difficult for the Federal Reserve to navigate to this soft landing scenario they keep painting, where they bring inflation down a lot, bring unemployment up a little bit, and at the same point in time don't really slow economic activity. In that backdrop where you do likely get some type of recessionary event at some point, who knows if it's this year, early next year, maybe not until 2025, intermediate part of the treasury market and intermediate part of the corporate bond market tend to do be the best performing areas to be in.

You get a good combination of total return and yield. And I think now, and Howard alluded through this earlier, is a very interesting point in time where we haven't seen these yields for a long period of time. You're getting paid to hang out and wait in intermediate duration space, and if the Federal Reserve does have to cut rates because we go into recession, well, yields will likely come down and probably come down fairly substantially. The market is forward-looking and we'll look to anticipate how far the Fed has to take rates down at some point in time. I think that's the real benefit of this intermediate-duration space is at this current point in time.

John Bryson:

Great. And Howard, my last question for you. We've talked a lot in the past about the value of active management in fixed income. Where are you and Jeff and team seeing opportunities in spread sectors today? How do the opportunities stack up between investment grade and high yield corporate, et cetera?

Howard Greene:

Yeah, so right now our favorite sector or sectors continue to be agency mortgages. That's the area of the portfolio that we have increased most dramatically over the past year. We've done that by reducing corporate bond exposure, both investment grade and high-yield. And we also like the asset-backed security sector. It's shorter duration, zero to five years. It's a good anchor there. It's one of our bigger relative overweights, our exposure relative to it's weighting in the benchmark. But it's important to note that this is classic late-cycle positioning, right? We've been reducing our exposure, as I said, to both IG and investment grade and high-yield credit for the past year and a bit longer, while taking on that more defensive, less cyclical exposure, while taking on a more defensive exposure and less cyclical within the credits we do own. It's that time in the cycle where you generally want to be cautious, lying in the weeds, waiting for a better opportunity to reload.

If the Fed pushes a little bit harder, the economy slows a little bit, there is that opportunity or the expectation that corporate credit could get a little cheaper, even cheaper than it's priced now. And when we get more clarity on when the Fed is near the end, when we've seen the worst in the economy or expect things to turn, that'll be the time to again reduce some of that more defensive exposure and get more exposed to the credit market. But right now, I mean, we've been through several cycles before, Jeff and I, doing this, and this is not necessarily the time to step up and be a hero, just time to be a little cautious.

John Bryson:

Very good. Well, we appreciate your experience and you sharing your insights. You've always been there for us. Whenever we have questions, our audience, I'd like to tell you that if you want to hear more, please subscribe to the Portfolio Intelligence podcast. You can do it on iTunes or on our website, jhinvestments.com. You can also read Viewpoints from Howard and Jeff and a number of our managers on what's going on in the market. We have pieces on portfolio construction techniques, business building ideas, and much, much more. As always, thanks for listening to the show.