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Last March, on March 17th to be exact, we sent the following text to a trusted bond manager:
“How concerned are you about a full-blown credit crisis? Are you detecting any structural issues in the corporate bond markets?”
Minutes later we received this reply:
“Yes, never seen anything like this before. I believe it will get worse before better. I’ve never seen this type of illiquidity in the investment grade bond market.”
Needless to say, this definitely caught our attention. And for the next six days it did get much worse. Then, on March 23rd, the Federal Reserve came to the rescue and threw their full support behind the USA…and global for that matter…economy. Almost immediately, the bond market stopped cratering and proceeded to march higher throughout the rest of 2020.
As we are now twelve months removed from that extreme environment and facing the potential of rising interest rates and inflation, we felt it worth assessing the current considerations for bonds. Thankfully, the trusted bond manager was willing to provide his insights. That individual is Tim Tarpening, Managing Director and Portfolio Strategist for Pacific Income Advisers, a $5 billion bond manager based in Santa Monica, California. We had the great fortune of meeting Tim in 2000 and have continued to benefit greatly from his now 37 years of investment experience. Below are key highlights from Todd Peters, Chair of our Investment Committee, conversation with Tim on March 29th.
How do you explain the bond market’s performance over the past year?
Three things drove the market: 1) the combination of fiscal (USA Government) and monetary (Federal Reserve) relief was historic, particularly since they occurred at the same time, and had the major impact; 2) momentum-oriented trading programs, where the primary focus is price trends, produced massive moves; and 3) the stealth-like acceptance of Modern Monetary Theory (MMT), which…in its simplest terms…states that if you can borrow in your currency (i.e. the USA Dollar) at low interest rates than it is prudent to do so, also played a significant role. To me, this was a perfect storm of events that resulted in the turnaround from the March 23, 2020 low.
What impact are you seeing from the continued fiscal and monetary efforts?
This new $1.9 trillion package seems to be moving the needle. Interest rates have started to move up. And we are having significant discussions on the potential return of inflation. Since 2008, the Federal Reserve has been trying to no avail to achieve a 2% inflation rate. At the present, though, it is starting to feel like a real possibility.
Are you concerned about inflation?
Before I worry about inflation, it must come from an “organic” economy and not a “goosed” one by Federal Reserve actions. So, I am not overly worried about runaway inflation. Even if inflation rises this year, I will not consider it a true long-term inflation trend.
What do you make of the recent interest rate increases?
My initial thought was that if the USA Government continues to throw money into the system then interest rates will go up even if inflation is not present. On average, the government contributes between 14% to 17% to the overall economy each year. In 2020, that percentage peaked at 39%. That is not sustainable if one wants to keep interest rates low. I feel the recent increases are a response to the proposed spending initiative and data released from Federal Reserve meetings.
Do you have any interest rate targets?
While impossible to forecast, at the beginning of each calendar year I do try to give myself a working range, particularly on the 10-Year Treasury. For 2021, my 10-Year Treasury range is 1.25% to 1.75%. Today it is @1.70%. We will have to see what additional data presents itself from here, but we have witnessed a substantial percentage increase already. It is possible that we do not move much higher.
How are you positioning portfolios in this environment?
Interestingly, our total portfolio exposures are very similar to the 1Q 2020 before the pandemic hit. We are focusing on bonds with meaningful trading volume (liquid), from companies with high quality balance sheets, and with maturities over the next couple of years.
Concluding thoughts?
It is a tough environment. The tight rope is how to generate positive returns while trying to avoid overvalued bonds. People are still paying for risk. Presumably thinking the government is going to keep flooding money into the system. This the challenge: balancing a momentum-driven market with the fundamentals of valuation.