Already Muted Credit Spreads Suggest High Quality, Longer Duration Bonds Is Place To Be

By Gary Stringer, Kim Escue and Chad Keller, Stringer Asset Management

There was no surprise that the federal funds rate was left unchanged at the Federal Open Market Committee (FOMC) meeting in December. It was made clear with additional statements that we should not expect to see further rate cuts in 2020. With some mixed signals in economic indicators, low inflation, and mounting geopolitical risks, it would also be unlikely to see rate hikes, especially after the U.S. Federal Reserve’s apparent oversteps in raising rates in 2018 that led to a yield curve inversion. This would indicate a range bound 10-year Treasury yield and minimal interest rate risk in the near term. It is our opinion that with the pause and the fact that the yield curve inverted, we might expect to see more risk for credit than interest rates.

The yield curve is a strong indicator for economic slowdowns and Fed policy mistakes have been the cause of every U.S. economic recession since World War II in our opinion. Recessions usually follow a yield curve inversion with a long lag time as past recessions have occurred 8 to 18 months after a curve inversion. That means we are not out of the woods yet. While we remain cautiously hopeful that the Fed may for once side step a policy mistake, credit spreads are so narrow that investors are not getting paid for the risks in our view.

Credit spreads for BBB rated corporate bonds are running over 70 basis points lower than their historical average. Below investment grade bond yields are even lower at nearly 200 basis points under their historical average. Based on the usual lag time between a yield curve inversion and a recession, there could be some additional pressures on corporate bonds, such as BBB investment grade and high yield. Corporate bond spreads could widen well ahead of a recession as they tend to be an indicator themselves. In our opinion, investors are not being paid to take on credit risk at this point.

The yield curve has now normalized, which makes the thought of taking on some level of duration risk more appealing. With corporate bond spreads at historical lows, higher quality bonds, such as taxable municipals and government bonds with durations in the 7- to 10-year range, look like a more attractive space to pick up additional yield in the current environment where there is little risk of inflation. In our opinion, long-term interest rates will be contained in a range for now. If the inverted yield curve this past summer turns out to be indicative of a recession, then we could see longer rates move down significantly and higher quality longer duration bonds should outperform.

With mixed economic indicators and the normal lead time of a yield curve inversion to a recession it is hard to make the case that investors are being fairly compensated for credit risk at this point. With little inflationary pressure, picking up yield in higher quality bonds in the 7- to 10-year duration range makes more sense as they offer more protection and less downside risk in our opinion.

This article was written by Gary Stringer, CIO, Kim Escue, Senior Portfolio Manager, and Chad Keller, COO and CCO at Stringer Asset Management, a participant in the ETF Strategist Channel.


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