The higher-for-the-longer price system is squeezing US recession bargains

  • US bond investors are reviewing recession bets
  • Economic resilience and financial concerns boost returns
  • Some are taking on more risks by shifting their Treasury bond allocations
  • But new deals come with caveats because of the overall uncertainty

NEW YORK (Reuters) – Bond investors who put their portfolios on the defensive in anticipation of a recession in the United States are adjusting their strategies for a surprisingly resilient economy that is likely to keep interest rates higher for longer than they expected.

The so-called soft economic path — in which the Fed manages to curb inflation without causing output deflation — has gained greater consensus in recent weeks, prompting some investors to take more risks or reduce bets on safe-haven assets such as Treasuries will also rise.

Philippe Villarroel, a portfolio manager at TwentyFour Asset Management, which specializes in fixed income, said he was shifting some allocations from 10-year Treasury bonds to 10-year investment-grade US corporate bonds. This reflects the accumulation of positions in 10-year US government bonds that began a year ago when yields were rising on the back of interest rate hikes by the Federal Reserve.

“The downside risk is priced in, and that doesn’t mean we’re too optimistic about the economy, but it does mean that the weighted average scenario has improved,” he said.

For investors who expected more economic strife, sticking to these calls has become more difficult. Over the past year, the unemployment rate has remained stubbornly low, and growth has been consistently above trend.

“It will take longer for prices to rise,” said John Madziere, senior portfolio manager and head of US Treasuries and TIPS at Vanguard Fixed Income Group. “As a result, we have scaled back those situations and expect them to happen much later than we previously anticipated.”

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Treasurys generally become more valuable, meaning their yields fall, during periods of economic weakness, but long-term yields have risen in recent weeks, with the 10-year index hitting a nearly 10-month high on Tuesday.

In addition to pricing in more economic flexibility, bond investors are also taking into account the Bank of Japan’s recent shift in yield curve control policy, issues around US debt sustainability as highlighted by the downgrade of Fitch’s rating in the US, and the large financing requirements announced by the Treasury Department.

“Recession or no recession, we believe the likelihood of higher interest rates for longer is much greater than the likelihood of reductions in the near term,” Oaktree Capital, the credit investment firm, said in a recent note.

The company has changed provisions, with the aim of raising interest rates for longer, for example by investing more in floating-rate debt, Danielle Polley, managing director and co-manager of the Oaktree Diversified Income Fund, told Reuters. However, Oaktree has now become more selective in leveraged financing, a sector in which borrowers are more vulnerable to higher borrowing costs.

Long-term concerns about the US fiscal health have recently boosted 30-year Treasury yields by about 20 basis points, said Anthony Woodside, head of US fixed income strategy at LGIMA.

He said he expected premiums for term insurance, or the compensation that investors demand for holding long-term bonds, to continue to rise.

“We’ve been tactically setting yield curve stressors in recent weeks, but we’ve put relatively tight risk limits on these trades given the high levels of volatility,” Woodside said.

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With the bulk of the most aggressive monetary tightening in decades likely in the rearview mirror, many on Wall Street admit they got it wrong.

“I think the biggest liability for me personally, but also I think, broadly across the market, is the misunderstanding that interest rates can be higher for longer and there can be no recession, which would be risk positive,” said Stephen Dover, senior Market Strategists at Franklin Templeton Investment Solutions.

So-called risk assets such as stocks and high-yield corporate bonds, which tend to perform badly during recessions, have emerged strongly from last year’s recession while safer bets such as US Treasury bonds lagged.

However, the growing optimism about a soft landing comes with several caveats, making it difficult for investors to embrace the prevailing macroeconomic outlook with conviction.

Acceleration of inflation may again lead to higher rates than the market expected. This would increase the chances of a sharper economic slowdown. Meanwhile, the delay in the full impact of a rate hike by the Fed could unnerve investors.

Some deal with uncertainty by combining exposure to short-term, high-yield bonds with longer-term bonds in deflation.

Chip Haughey, managing director of fixed income at Truist Advisory Services, said he recommended an “iron structure” that hedges short-term papers with long-term bonds “if we move further into risk-averse.”

For Madziyire’s team at Vanguard, this meant trades got smaller.

“There is discretion for portfolio managers to take a position, within a certain tolerance, but it wouldn’t be a big thing,” he said. “This is indicative of the fact that there is a lack of consensus about where we are going.”

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Reporting by Davide Barbuscia. Editing by Richard Chang

Our standards: Thomson Reuters Trust Principles.

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Davide Barbuscia covers macro investing and trading outside of New York, with a focus on fixed income markets. Previously based in Dubai, where he was Reuters’ chief economic correspondent for the Gulf region, he has reported on a wide range of topics including Saudi Arabia’s efforts to diversify away from oil, the financial crisis in Lebanon, as well as corporate sovereign debt deals. and restructuring. Prior to joining Reuters in 2016, he worked as a journalist for Debtwire in London and had a stint in Johannesburg.

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