Weekly Update (10-03 – 10-10): Bond Investing in Volatile Markets

Hi all –

Happy October! We wanted to send out an update on what we are seeing in markets as we enter the fourth quarter of 2023.

• As we anticipated heading into 2023, bonds have been a difficult asset class to own. While we believed late last fall that stocks had likely reached a bottom, we were unsure whether the same was true for bonds. Bond prices are largely determined by interest rates, and interest rates have gone up rapidly this year. Interest rates affect stocks, too, but stocks can also be moved by future expectations about earnings, which have broadly improved as of late.

• Nonetheless, we believe bonds are an important asset class to own, we do believe we must be more thoughtful than purely owning the index. While “AGG” the Barclays AGG, the most widely used bond benchmark, is down 1.71% year-to-date, our bonds have performed very well, up in the range of 1 - 2%.

• While our view is that the AGG owns too many treasuries and “mortgage-backed securities,” or bonds which are tied to home loans, we believed and continue to believe the corporate markets, both high quality and high yield, offer more attractive rates and better quality.

• We have taken a “short duration” stance, vs the benchmark. Duration is a mathematical expression of the approximate amount a bond may move if interest rates go up or down. A bond with a duration of 10 would go down by 10% if interest rates go up 1%, or would go up by 10% if rates go down by 1%.

• Our short duration stance has allowed us to capture a very high level of income, by taking very little interest rate risk.

• We have been slowly selling exposure to broad bond benchmarks to gain exposure to high yielding bonds that are earning between 7-8%. We are “locking in” these yields since we are buying them in an ETF wrapper, and they mature in the years 2025, 2026, and 2027. These are attractive products because rather than buy a single bond from a single issuer, we are able to get broad, diversified exposure with every little interest rate risk, but paying us high income levels.

• Since most of the underlying bonds held in these ETF’s are trading “below par” (or below the $100 our bonds are contractually obligated to pay us back), we get built in price appreciation with the 5-7% “coupon” payments that are also contractually paid to us.

• Since ten-year yields have made a historic upward move this year, going up over 100 basis points, we have avoided a lot of pain in fixed-income land, and managed to squeeze out a positive return.

• Our viewpoint hinges on the economy remaining strong, we are seeing GDP stay positive with the Fed GDPNow tool signaling 5% economic growth.

• Inflation also looks to be cooling down, and we expect no further rate hikes in 2024 due to the election year (which is how most prior Fed’s have acted during an election year.)

• If the status quo remains, we expect a soft landing to materialize (we are in Goldman Sachs’ camp of a below consensus 15% chance of a recession over the next twelve months.) If this occurs, we will continue to earn very good yields from these bonds, and the bonds will continue to provide “ballast” against our equity positions.

• We reserve the right to change our positioning if the market deteriorates; although right now we aren’t seeing signs of that occurring. Most of these bonds were issued in a lower interest rate environment, and as such the coupons they pay are not so overwhelming to the companies making the payments.

• If the Fed only has one final rate hike (or zero), this will not likely be enough to send the economy into a recession, and earnings growth and an economic recovery will ensue.