Tuesday, March 29, 2022
The Strategic and Tactical Asset Allocation Committee (STAAC) is the investment committee broadly charged with overseeing the investment decisions for LPL’s discretionary asset allocation platform. The 12 member committee is comprised of the senior members within LPL’s Research department and is responsible for the firm’s stock and bond views that ultimately form the firm’s asset allocation decisions. The committee meets weekly to discuss current market views and in a recent meeting, the committee voted to update its current thinking/positioning in a number of fixed income areas.
Higher Expected Treasury Yields
For 2022, near-term inflation expectations above historical trends and improving growth expectations once the COVID-19 variants receded were reasons why the committee thought interest rates could move moderately higher this year. We expected the 10-year Treasury yield to end the year between 1.75% and 2%. However, as inflationary pressures have broadened this year, the Federal Reserve (Fed) will likely be forced to tighten monetary policy quicker than we originally expected. As such, we now expect the 10-year Treasury yield to end the year between 2.25% and 2.50% with risks to the upside.
As this is a yearend target, there is a high likelihood that yields could eclipse 2.50% in the near term, depending on the path of inflation over the summer months. If inflationary pressures fade over the course of the year, potentially resulting in a less aggressive rate hiking campaign, it’s likely that yields could move lower from current levels. However, if inflationary pressures remain stubbornly high forcing the Fed to follow through or exceed market rate hike expectations, yields could continue to climb higher.
Increased Opportunities in Short Maturity Investment Grade Corporate Credit
As mentioned above, fixed income markets have meaningfully repriced the expectations for Fed rate hikes with the biggest repricing occurring for shorter maturity securities. As seen on the LPL Chart of the Day, yields have increased by as much as 100 basis points (1.0%) for investment grade (BBB-rated) corporate credit instruments broadly but with significantly (> 150 basis points) higher yields in those securities with 1-5 years until maturity. With total yields ranging from 3.00% to 3.50% in these shorter maturity securities, we think there is currently an opportunity to add to this area of the market without taking on elevated levels of interest rate or credit risk. We retained our slight underweight to interest rate sensitivity at the portfolio level.
“With yields moving higher recently in most fixed income markets, future returns for fixed income investors have likely improved,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “While there’s no guarantee that yields can’t go higher, at current levels, which are above pre-COVID-19 levels in most markets, valuations for many fixed income assets are starting to look interesting again.”
Increased Opportunities in High Yield vs Bank Loans
An important point about the negative returns we’re seeing this year is that yields are moving higher because of the expectations of higher short-term interest rates and not an increase in credit risk. Corporate fundamentals remain strong with net leverage ratios and expense coverage ratios well within historical averages. With total yields in high yield bonds approaching historical averages, though, with arguably a higher-quality index disposition, the repricing we’ve seen in the non-investment grade corporate credit markets has been unevenly distributed to high yield bonds and not bank loans. As such, for income oriented investors, the value proposition for high yield bonds has improved.
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.
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All index and market data from FactSet and MarketWatch.
This Research material was prepared by LPL Financial, LLC.
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