Longer high rates put pressure on US recession trades.

Bond Investors Adjust Strategies as Resilient Economy Surprises

Bond investors who had anticipated a U.S. recession and positioned their portfolios defensively are now adjusting their strategies as the economy proves to be surprisingly resilient. This adjustment is driven by the expectation that interest rates will remain higher and for longer than initially expected.

The market consensus is increasingly leaning towards a soft-landing economic scenario, in which the Federal Reserve manages to control inflation without causing a contraction in output. Consequently, some investors are taking on more risk or reducing their bets on safe-haven assets like U.S. Treasuries rallying.

Felipe Villarroel, portfolio manager at TwentyFour Asset Management, specializing in fixed income, shared his strategy of shifting allocations from 10-year Treasuries to 10-year U.S. investment-grade corporate bonds. This is a reversal from a year ago when yields were rising due to the Fed’s interest rate hikes. Villarroel noted, “The tail risk of a hard landing is being priced out, and that doesn’t mean we’re too bullish on the economy, but it does mean that the weighted average scenario has improved.”

The challenge for investors who predicted an economic downturn is sticking to their original calls. The unemployment rate has remained low, and growth has consistently exceeded expectations over the past year. As a result, John Madziyire, senior portfolio manager at Vanguard Fixed Income Group, stated, “It’s going to take longer for rates to rally. As a result, we have reduced those positions and expect them to happen way later than we expected previously.”

Typically, Treasuries become more valuable, leading to declining yields, during periods of economic weakness. However, long-term yields have recently spiked, with the benchmark 10-year hitting a nearly 10-month high. Bond investors are considering not only the resilience of the economy but also the Bank of Japan’s shift in yield curve control policy, concerns over U.S. debt sustainability, and the Treasury’s large funding requirements.

Oaktree Capital, a credit investment firm, believes that the likelihood of higher-for-longer interest rates is greater than the possibility of near-term cuts. Danielle Poli, managing director and co-portfolio manager of the Oaktree Diversified Income Fund, explained that they shifted allocations to adapt to higher rates by investing more in floating-rate debt. However, they are now more selective in leveraged finance, a sector more susceptible to increased borrowing costs.

Concerns about the U.S. fiscal position have also contributed to a recent boost in 30-year Treasury bond yields. Anthony Woodside, head of U.S. Fixed Income Strategy at LGIMA, expects term premiums, the compensation demanded by investors for holding long-term bonds, to continue rising.

Low Conviction in Economic Optimism

Despite emerging optimism regarding a soft landing, there are several caveats that make it difficult for investors to fully embrace the prevailing macroeconomic outlook with conviction. A potential re-acceleration in inflation could result in higher rates than what the market has priced in, increasing the chances of a sharper economic slowdown. Furthermore, the full impact of the Fed’s rate hikes has yet to be fully felt, which can unsettle investors.

To navigate this uncertainty, some investors are adopting a “barbell structure,” combining exposure to higher-yielding short-term bonds with long-term bonds as a hedge against a downturn. Chip Hughey, managing director of Fixed Income at Truist Advisory Services, recommends this strategy to protect against moving into a more risk-off period.

For Vanguard, the uncertainty has resulted in smaller trades. According to Madziyire, “There is discretion for portfolio managers to put on a position, within a certain tolerance, but it is not going to be something big. That’s a function of the fact that there’s a lack of consensus as to where we’re going.”

In conclusion, bond investors are adapting their strategies as the resilient U.S. economy defies expectations of a recession. The shift towards a soft-landing scenario prompts investors to take on more risk and reduce positions in safe-haven assets. While optimism prevails, there are lingering concerns about potential inflation, the impact of past rate hikes, and the U.S. fiscal situation. Investors are employing various approaches, from shifting allocations to adopting a barbell structure, as they navigate this uncertain economic landscape.

Longer high rates put pressure on US recession trades.

Bond Investors Adjust Strategies as Resilient Economy Surprises

Low Conviction in Economic Optimism

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