Wealth Management
US Treasury yields surged to their highest levels in 16 years following the release of minutes from the July FOMC meeting. The minutes made clear that the Fed continues to lean in a hawkish direction despite some signs that the economy is decelerating, softness in the labor market, and moderation in inflation. Essentially, it’s another sign that rates will remain ‘higher for longer’ and that any pivot in Fed policy is nowhere near.
In the minutes, the Fed said that there were ‘significant upside risks to inflation, which could require further tightening of monetary policy’. Following the release, yields on the 10-year Treasury reached 4.3% which is the highest level since before the housing collapse and Great Recession in 2007.
In addition to the Fed, there are other factors that are contributing to selling pressure in Treasuries such as foreign governments reducing their holdings and expectations of supply hitting the market in the coming months due to the federal government’s funding needs.
Already, equity markets started to wobble and give back some of the gains made in recent months. Previous breakout in yields have resulted in sharp sell-offs in equities, and there is a risk that it could reignite the crisis in regional banks.
Finsum: US Treasury yields shot up to their highest level in 16 years following hawkish minutes from the July FOMC meeting. Other factors are also contributing to Treasury weakness, and it’s worth watching if it will result in damage to parts of the economy.
More than anyone else, financial advisors intuitively understand the value of planning in order to create successful outcomes. Their entire career is built around that concept, and they provide that service for their clients on a daily basis to help them reach their financial goals and attain a comfortable retirement.
So, it’s a conundrum that many advisors don’t apply the same rigor when it comes to their practices especially as it may impact their ability to recruit and retain clients if they are at a more mature age. Succession planning can also help advisors maximize the value of their business when it comes to selling, but it can be overwhelming given the variety of options.
A good intermediate step for advisors who are just beginning the process is to have a management succession plan and a buy/sell agreement in the event of a death or disability. A management succession plan details who will take control of the business in terms of operations. Typically, it’s an employee or possibly a trusted colleague in the industry. The buy/sell agreement is usually funded by life insurance and is a legal document that clarifies how ownership of the business is transferred if the principal unexpectedly leaves the business.
Both steps are essential as it guarantees the successful continued operation of the business, while assuring that the interests of the advisors’ heirs and family are also taken care of.
Finsum: Ironically, many financial advisors don’t take succession planning seriously. It’s understandable given the variety of options and implications, but here are some small steps to get you started.
A major theme of 2023 has been the constant compression in volatility. In fact, the volatility index (VIX) is now lower than when the bear market began in January of 2022 despite the S&P 500 being about 10% below its all-time highs.
However, the consensus continues to be that these conditions won’t persist for too long. The longer that rates remain elevated at these lofty levels, the higher the odds that something breaks, causing a cascade of issues that will lead to a spike in volatility and a probable recession. According to Vanguard, a shallow recession remains likely to occur sometime early next year.
For fixed income, it will certainly be challenging. So far this year, the asset class has eked out a small gain despite rates trending higher due to credit spreads tightening and low default rates. However, more volatility is likely if rates keep moving higher which would likely lead to selling pressure or if inflation does cool which would result in the Fed loosening policy, creating a generous tailwind for the asset class.
Given this challenging environment, active fixed income is likely to outperform passive fixed income as managers have greater discretion to invest in the short-end of the curve to take advantage of higher yields while being insulated from uncertainty. Additionally, these managers can find opportunities in more obscure parts of the market in terms of duration or credit quality.
Finsum: Fixed income has eked out a small gain this year. But, the environment is likely to get even more challenging which is why active fixed income is likely to generate better returns than passive fixed income.
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UBS shared its outlook on fixed income and high yield credit in a strategy piece. Overall, the bank is moderately bullish on the asset class, especially at the short-end of the curve, but doesn’t believe returns will be as strong as the first-half of the year.
Overall, it attributes strength in the riskier parts of the fixed income universe to a stronger than expected US economy which has kept the default rate low. This has been sufficient to offset the headwind of the Fed’s ultra-hawkish monetary policy.
The bank attributes the economy’s resilience to lingering effects of supportive fiscal and monetary policy and the strong labor market. It’s a different type of recovery than what we have seen in the past where financial assets inflated while the real economy struggled.
However, UBS believes that the default rate should continue to tick higher so it recommends a neutral positioning. It also sees a correlation between equity market volatility and high-yield credit. While this was a tailwind in the first-half of the year, it believes that it should be a headwind for the remainder of the year given high valuations.
Overall, it sees a more challenging environment for high-yield credit and recommends sticking to the short-end of the curve to minimize duration and default risk.
Finsum: In a strategy piece on high-yield credit, UBS digs into its strong performance in the first-half of the year, and why it expects a more challenging second-half.
In a piece for AdvisorEdge, James Langton discusses how banks are tightening their lending standards which could present an opportunity for alternative investment managers. According to a report by Fitch Ratings, there is a surge in interest for private debt from borrowers. In North America, private credit funds’ assets under management increased from $242.7 billion in 2010 to over $1 billion at the start of the year.
And, this trend should only accelerate in the coming years especially as regional banks are a key source of funding, and many are struggling with an inverted yield curve. The crisis in regional banks earlier this year underscored their perilous position. Thus, it’s not surprising to see a flurry of new private credit funds. In the second quarter, 34 new funds were launched, raising $71.2 billion, more than double what was raised in the first quarter.
Private credit is more insulated from rising rates due to its reliance on floating rate-loans. Additionally, default rates have remained at historically low levels at 1.6% in Q2 and 2.2% in Q1, indicating that the overall economy remains resilient and rewarding investors in these funds.
Finsum: Funding from banks is increasingly difficult to access given tighter credit standards and challenges for regional banks. This is creating an opportunity for alternative investment managers as private credit funds step into the void.
Although 2022 was the worst year for bonds in recent history, there are some silver linings for fixed income investors according to WisdomTree’s Andrew Okrongly and Behnood Noei who are the firm’s director of model portfolios and fixed income, respectively. These are the highest yields in decades which is bringing ‘income back to fixed income portfolios’ and the potential for significant returns. The second is reduced duration risk given that short-term bonds are offering generous yields.
The current environment is significantly different from what prevailed for much of the last 2 decades when bonds both trended higher with minimal volatility. However, the asset class became less appealing due to higher levels of duration risk in addition to miniscule yields. As a consequence, many fixed income investors went further out on the risk curve to find yield whether it was junk bonds, EM debt, or dividend-paying stocks.
Now, investors can find much higher levels of yield with much less risk. Therefore, fixed income can return to its traditional role of providing income and safety in portfolios. In fact, it’s a rare circumstance that shorter-term bonds are offering much higher yields than longer-term bonds with less risk. And, these conditions should persist given current Fed policy and the economy’s resilience.
Finsum: Investors should consider short-duration fixed income model portfolios given that they are offering higher yields with less duration risk.