Market Commentary

• The era of central banks driving bond markets is giving way to a more market-driven investment landscape.
• For investors, elevated yields are creating opportunities, but navigating volatility will require greater selectivity.

For much of the past 15 years, bond investors relied on a simple and consistent playbook. Long-term interest rates were low, inflation was quiet, and major central banks, especially the Federal Reserve (Fed), were major buyers of bonds through quantitative easing (QE). Fixed-income markets became accustomed to relatively low volatility and the belief that central banks would step in whenever financial conditions tightened too much. Also, investors became comfortable with the idea that bond sell-offs would be temporary and rates would remain relatively stable.

That world is changing. Today’s fixed-income market is influenced less by QE and more by inflation uncertainty, government borrowing needs, and shifting investor demand. In other words, the old playbook may no longer work as well as it once did.

In many ways, last week’s Fed meeting reflected the broader shift taking place across bond markets. Although Fed Chair Kevin Warsh emphasized that the Fed remains fully committed to its 2% inflation target, he signaled that the Fed may be rethinking how it communicates with markets. Warsh announced five task forces to review areas ranging from communications and inflation frameworks to balance-sheet policy and economic data.

The message was subtle but important. Rather than telling markets where rates are headed, Chair Warsh appears comfortable letting investors interpret the data for themselves and allowing market signals to play a larger role in policymaking. That approach fits naturally within the new fixed-income regime. Just as investors are adjusting to a world with less central-bank support and more uncertainty, markets may also need to become more comfortable forming their own views about the direction of interest rates and the economy.

First, expect more volatility than we saw during much of the QE era. Second, the “income” inside fixed income matters again. With bond yields still well above the levels investors experienced for much of the 2010s, simply collecting income can be a meaningful contributor to total returns. Third, not all bond sectors are created equal. Active allocations across high-quality investment-grade corporates, securitized assets, and municipal bonds may matter more than broad exposure to the market as dispersion is increasing. Finally, yield-curve positioning may become increasingly important with the intermediate part of the curve offering the most attractive balance of income and interest-rate risk, in our view.

For years, investors operated in a world where central banks did much of the heavy lifting. In the new fixed-income regime, markets may be on their own a little more, and that makes income, selectivity, and active decision-making increasingly important. 

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. Municipal bonds are subject to credit risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. Municipal securities are also subject to legislative and regulatory risk which is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income. In addition to the risks associated with investments in debt securities, a strategy’s investments in securitized assets, such as mortgage-backed and asset-backed securities, are subject to prepayment, extension, and call risks. Changes in prepayment rates may significantly affect yield, average life, and expected maturity. Prepayment risk refers to the possibility that underlying borrowers repay principal earlier than expected, particularly in declining interest rate environments. Extension risk is the risk that rising interest rates will slow the rate at which underlying mortgages or loans are prepaid, thereby extending the duration of the securities. Call risk is the risk that, if a security is called prior to maturity, comparable investments with similar yields may not be available for reinvestment. These risks may be more pronounced for securities with longer maturities or durations.

An index is unmanaged and not available for direct investment.

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