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Don’t You (Forget About Me)

“Will you recognize me?
Call my name or walk on by
Rain keeps falling, rain keeps falling
Down, down, down, down”

- Simple Minds (written by Keith Forsey / Steve Schiff)

These days it’s tempting to want to forget about the bond market.

As investors review returns from Q1-2022, the toughest questions are emerging from the most unlikely of places: Treasuries, Municipal bonds, and Investment Grade bonds – all areas that are meant to calm us are now creating anxiety…But…Let’s not forget about bonds.

In our (simple) minds, after seeing prices fall “down, down, down, down,” yields may now indicate that it’s time for investors to consider bonds. Here we evaluate the question of how the historic poor bond returns of Q1-2022 plays out as we have experienced what appear to be peak inflation readings and embark on potentially the most active period of the emerging Fed tightening cycle.

Our primary observation is that we believe the short-end of the yield curve appears to have priced in more Fed hawkishness that may unfold. Short-duration bonds, which have lower interest rate sensitivity, may now be attractive for investors.

To put this recent move in perspective, the magnitude of the current market adjustment is 50% larger than and twice as fast as the last tightening cycle in 2018.

20220419-chart-1If headline inflation peaked in March, as we expect, then it’s likely that the 2-Year Treasury has more than fully priced in Fed policy shifts for this cycle. Alternatively, if inflation accelerates from here we believe the Fed will push faster to slow the economy and the 2-year treasury could increase in price. However, if the Fed moves too aggressively the risk of recession could increase. In either case, the next few months could be headlined by 50 basis point rate increases combined with a steady reduction of the Fed’s balance sheet – creating more volatility for longer duration bonds than we’re comfortable with.

However, as we head into the back-to-school season (September-ish) we believe the core of both investment grade corporate and US Treasury bonds may become more attractive. In other words, we may have seen the worst of the bond market rout with the potential for an improving environment for investors to consider longer duration exposure.

Another observation that supports this idea is the history of drawdowns in the 10-year Treasury.

Going back to 1990, each time annual returns approached -10%, that portion of the curve rallied. The narratives were unique in each case but the subsequent annual returns from the lows of each drawdown were consistently positive.

20220419-chart-2The combination of the rapid sell-off in fixed income, aggressive Fed action, and slowing headline inflation give us reason to be constructive on bond prices. Although real returns remain low (or negative), we believe equity risk can be diversified with lower-risk/short-duration bonds.

In addition, as illustrated in the chart nearby, the recent drawdown reversal could set the stage for improved total returns across bond categories beginning later this year. So, don’t just “walk on by” the bond market. It’s time to recognize the opportunity.

Important Disclosures & Definitions

Performance data quoted represents past performance. Past performance is no guarantee of future results; current performance may be higher or lower than performance quoted.

Consumer Price Index (CPI): a measure of the average change over time in the prices paid by urban consumers for a representative basket of consumer goods and services. One may not invest directly in an index.

Headline Inflation: the raw inflation figure reported through the Consumer Price Index (CPI) that is released monthly by the Bureau of Labor Statistics which is derived from the cost to purchase a fixed basket of goods.

Short Duration Bond: generally, a bond with maturity of less than five years.

Short End of Yield Curve: generally debt instruments with maturities less than two years.

Tightening Mode: tight, or contractionary monetary policy is a course of action undertaken by a central bank such as the Federal Reserve to slow down overheated economic growth, to constrict spending in an economy that is seen to be accelerating too quickly, or to curb inflation when it is rising too fast.

Yield Curve: a graphical representation of the yields (y-axis) on debt instruments with different maturities (x-axis).

ALPS Advisors, Inc. is affiliated with ALPS Portfolio Solutions Distributor, Inc.

ALPS Portfolio Solutions Distributor, Inc., FINRA Member.

APS001960 04/30/2023

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