Morgan Stanley IM: Putting Income Back into Fixed Income

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Bond market woes were caused by a litany of factors: better than expected U.S. employment, worse than expected inflation, the U.S. Federal Reserve (Fed) raising expected terminal rates meaningfully. These factors were compounded by the now infamous UK bond market meltdown over the second half of the month. Sovereign yields and credit spreads moved substantially higher in September. Credit markets were clearly impacted by the rise in yields, turmoil in the UK, and, maybe most importantly, the rising probability of a recession or hard landing. Also, not surprisingly, the U.S. dollar was strong once again, rising in value against almost all of the world’s currencies. That’s the bad news.

The good news is that yields across the fixed income universe reached levels that should provide decent protection against further rises in yields. For example, high quality 10-year investment grade financial debt now yields around 6%. Even if yields/spreads rise another 50-75 basis points (bps), total returns over 12-month periods should be positive—a major change from the beginning of the year. And, we believe, eventually the economy will soften, inflation pressures ameliorate and government bond yields will fall, further cushioning the impact of potentially wider spreads.

The news in September was generally negative for bonds. Whether it was a U.S. labor market showing no imminent signs of softening, or U.S. inflation (core CPI) rising from a 0.3% month-over-month change to a 0.6% month-over-month change. News from Europe and elsewhere also remained poor on the inflation front. It is likely. In our view, that Eurozone inflation will stay in double digits into 2023 at least. And, with fiscal policy easing to varying degrees, headwinds for monetary policy are likely to get a bit stronger given additional fiscal support to households and businesses. It seems nowhere in advanced economies is there optimism that central banks have hiked enough. Even in Australia, where the central bank surprised markets by “only” raising rates 25 bps rather than the expected 50 bps, the cumulative amount of tightening the central bank expects to deliver remained unchanged.

DISPLAY 1: Asset Performance Year-to-Date

^{Note: USD-based performance. Source: Bloomberg. Data as of September 30, 2022. The indexes are provided for illustrative purposes only and are not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See below for index definitions.}

The impact of poor inflation data was felt particularly hard on real yields. The U.S. 10-year real yield rose almost 100 bps in the month, an amount rarely seen in any one-month period. This of course implied that inflation expectations fell over the month (nominal 10-year yields did not rise as much, meaning 10-year breakeven inflation spreads fell). This suggests the Fed has gained credibility in its inflation fight. In other words, the market increasingly believes Fed rhetoric that it will raise rates to “whatever it takes” to bring inflation down to target (circa 2%). It also implies higher probability of a recession in 2023 or a long period of subpar growth as that is what it usually takes to push inflation meaningfully lower.

Markets were additionally challenged by events in the UK. An unprecedented wave of selling, first of long-dated UK government bonds and then other Euro and USD denominated bonds, led to wild gyrations in UK government yields and significant price deterioration in corporate and securitized bonds. For example, the UK 30-year government bond yield was rising steadily over the month until September 27/28, when it suddenly rose 94 bps, only to fall 105 bps on September 28, after the Bank of England (BoE) announced it would buy billions of pounds of long gilts to ensure financial stability. While it clearly worked to stabilize the market, subsequently, 30-year gilt yields are back up 46 bps as of October 7. The index linked gilt market, a large market mostly used by UK insurance companies and pension funds, had even worse volatility. This episode was the first example of something “breaking” from the rapid rise in yields in 2022. Of course, it does seem leverage was the trigger, as it usually is during financial crises. Whether or not there are other skeletons lurking in investors’ closets remains to be seen.

DISPLAY 2: Currency Monthly Changes Versus U.S. Dollar

^{Note: Positive change means appreciation of the currency against the USD. Source: Bloomberg. Data as of September 30, 2022}

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^{Risk Considerations}

^{Diversification neither assures a profit nor guarantees against loss in a declining market.}

^{There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in a portfolio. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. High-yield securities (junk bonds) are lower-rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, and correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Due to the possibility that prepayments will alter the cash flows on collateralized mortgage obligations (CMOs), it is not possible to determine in advance their final maturity date or average life. In addition, if the collateral securing the CMOs or any third-party guarantees are insufficient to make payments, the portfolio could sustain a loss.}