Here is a sampling of total returns thus far in 2018:
Broad Market Index -1.7% Investment Grade Corporate Index -2.6%
Treasury market Index –2.1% Mortgage Index -1.1%
High Yield Corporate Index 1.1% CCC Index 5.4% Muni Market Index -0.01%
5 Yr. Treas. -1.4% 10 Yr. Treas. -3.5% 30-Yr. Treas. -5.4% Long munis -0.6%
Despite the very gradual nature of Fed “policy normalization”, the long-duration segments of all the markets recorded significantly negative returns. Only the weaker credits have performed reasonably well.
Now we very likely face another 50 basis points increase in the fed funds rate over the next five months. We must also confront a much heavier pace of Treasury borrowing than during the past seven months. The refunding announcement yesterday was a stark reminder of how much the note and bond auctions will be increased.
The FOMC statement today provided no support to speculation that the Fed might pause to assess the impact of tariffs on the economy. Rate increases in September and December remain the most likely policy path.
Should we expect bond yields to rise another 50 basis point by year end? Perhaps not that much because yields are approaching levels that insurance companies and pension funds can live with. For total return managers, however, it is probably still too early to move much beyond 5-year durations. Negative returns on the longer durations are much more probable than positive returns.
The more difficult question is how to approach the high yield market. The outlook for the economy remains favorable, so default rates should remain low. Thus, it is probably too early to scale back exposure to that market. But it might not be too early to scale back exposure to the CCC and weaker credits. They have performed very strongly over the past 18 months, so spreads to Treasuries have become relatively narrow. Not owning those credits could hurt performance over the short-term, but could prove prescient over the longer run.