Wednesday, August 9, 2023
Many investors labelled 2023 as the “Year of the Bond” following 2022’s historic bond rout (the Bloomberg U.S. Aggregate Index (Agg) declined 12%). Broadly, fixed income returns are positive across the board in 2023. However, high quality core bond returns (proxied by the Agg) have materially lagged the returns of riskier plus sectors like high yield bonds, bank loans, and emerging market debt, countering many market participants‘ expectations at the start of the year. While returns in core bonds have lagged expectations in 2023, retail flows have seen a sharp reversal after investors fled taxable bond funds in 2022 (~$200 billion per Morningstar data). Why are core bond fund flows particularly important in 2023? What’s more surprising, high yield funds have seen outflows and have still managed to generate over 6% return YTD. How is this possible?
Per Morningstar data, the chart below shows open-ended intermediate core and core plus bond funds (mutual funds and ETFs) have had strong inflows of over $100 billion during the first half of 2023, representing roughly 80% of total 2023 inflows for taxable bond categories. These inflows come at an opportune time, allowing money managers to support the bond market as two important buyers step back—the Federal Reserve (Fed) and banks. As the Fed continues to run quantitative tightening (QT), it has actively stepped back from Treasury and mortgage-backed securities (MBS) markets. Additionally, elevated front-end rates incentivize investors to pull cash out of bank deposits and allocate to products like money market funds and other cash-like alternatives. Declining deposits equates to lower reserves needed by banks, which equates to banks stepping away from high quality bond markets as well. As two key market participants and their natural bid step back from the market, money managers need to fill in this demand gap. So far in 2023, that hasn’t been a problem given the positive inflows, providing a bid to high quality core bond sectors.
As the chart above shows, high yield credit funds (bonds and bank loans) have seen outflows over the last 18 months. The resilience of high yield credit returns despite investor outflows is a good example of the technical aspects of the bond market. In simplest terms, high yield supply slowed in 2022 and has continued to do so in 2023. According to JPMorgan Market data, 2023 high yield supply is 42% lower than the four year average (excluding 2020). This lower supply helps to offset investor outflows as the market avoids becoming over saturated with high yield debt, which would push yields higher and returns lower for investors. This recent lack of supply of high yield credit is partly explained by the war chest of liquidity high yield issuers built during the ultra-low rate environments of 2020 and 2021. However, roughly $785 billion of high yield bonds are set to mature between 2024 and 2026. This may lead to high yield supply closer to historical averages as issuers re-tap the market, and this supply may become a technical headwind if supply outpaces demand, particularly if economic growth slows.
We expect high quality bond fund inflows to continue as yields have reached levels not seen since 2008 (the Agg recently reached a yield-to-worst of roughly 5%). High quality core bond funds with yields in the 4–6% range are reasonable alternatives to other asset classes, particularly for investors fearful of an economic slowdown. Starting yields are the best predictor of long-term returns. We also expect core bond fund inflows to outpace sectors like high yield bonds over the near-term given materially lower credit risk. These inflows will provide stability to the bond market as the Fed and banks take a step back. We continue to favor core bonds over high yield credit broadly as investors no longer have to reach for yield.
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