How bad is bond market carnage? This unlikely sector is down 10% as inflation weighs on returns.

High-quality bonds should hold up better than stocks, right? Especially if the defaults aren’t really the concern.

But that hasn’t been the case lately for the debt issued by many Fortune 500 companies, a sector particularly hard hit since the Federal Reserve shifted its stance to urgently cool inflation.

Investment grade U.S. corporate bonds, debt sold by many large companies in the S&P 500 SPX index,
posted a negative total return of 10% so far in 2022 (see chart), after posting their worst quarterly loss since the global financial crisis, according to Mizuho.

Few financial assets are posting even modestly positive returns so far in 2022.

Mizuho Titles

The high-quality corporate bond rout compares to a total return of around minus 6% for the S&P 500 SPX Index,
and a negative performance of -6% for bonds issued by municipalities and high yield companies.

“We are in a challenging environment,” said Jack McIntyre, portfolio manager at Brandywine Global Asset Management. “Bonds are selling, stocks are selling. The real return on cash is negative.

McIntyre expects the bonds to be a “great buy” at some point given the steady rise in yields, although he expects challenges along the way.

On the one hand, the Fed needs to figure out how much to raise its key rate to help curb inflation, which is at its highest level in 40 years, while shrinking its balance sheet by nearly $9 trillion, all without harm the economy.

To see: Yellen says it’s not impossible for the Fed to stage a soft landing for the US economy

Many on Wall Street now expect the Fed to hike the fed funds rate by half a point in May, while initiating “quantitative tightening” or shrinking its balance sheet, at its fastest pace on record. .

The hope is that rates, including the benchmark 10-year Treasury yield TMUBMUSD10Y,
stabilize and help put bonds on a more solid footing. Corporate bonds and other debt that come with credit risk are priced at a spread, or premium, above the Treasury’s risk-free rate, which has risen significantly this year as Fed officials spoke more inflation hard.

A turning point?

Corporate defaults have remained low, after an early deluge during the pandemic, and could remain so for a few years, given the very low cost financing that many large companies have secured over the past two years.

That doesn’t make it easy for investors holding trillions of low-coupon bonds that don’t have to be redeemed for about a decade, or even longer in some cases.

“I think individual investors are still licking their wounds, given the negative total returns,” said Travis King, head of investment grade credit at Voya Investment Management. “But we think with yields around 4%, it’s starting to look like a better entry point, especially if there’s stability in the Treasury market.”

King also said other positive signs emerged in the form of increased day-to-day buying activity by Asian investors in high-quality corporate bonds.

“It’s definitely buoyed our market,” King said, though he’s also worried about rising hedging costs that could dampen overseas appetite. “If the Fed ends up raising rates by 50 basis points in multiple meetings, those hedging costs become more expensive.”

The path of inflation is everything

Looking ahead, the focus will be on the path of inflation, after US consumer prices rose 8.5% year-on-year in March, the fastest pace faster since January 1982.

David Norris, head of US credit at TwentyFour Asset Management, sees hope in easing prices for used cars and other segments of the consumer price index, but also potentially greater stability with the 10-year Treasury rate around 2.7%.

“At the end of the day, I think we’re close to peak inflation at 8.5%,” Norris said, by phone. While the Fed plans to raise interest rates this year, he also expects that over the next two quarters the central bank will have to reassess the state of the economy and perhaps decide that the policy rate will not need to be adjusted. aggressively higher.

“Over time, we’ll see how the economy is able to withstand rate hikes,” Norris said.

Brandywine’s McIntyre warned of unusual times. “It’s a bit of a Volcker moment, and marry that with a Putin moment,” he said, referring to the CL.1 oil price spike,
and in other commodities after Russia’s invasion of Ukraine and the early 1980s recession triggered by former Fed Chairman Paul Volcker’s battle with high inflation.

“Something is going to break,” McIntyre said. “Ideally it’s inflation, so that means the Fed blocked the landing.”

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