September has historically been the worst month for stocks, which have fallen a median 0.42% and experienced negative returns over 55% of the time going back to 1928.[1]  And while not much else in the market is performing as it usually does in this very unusual year, stocks have so far followed this historical pattern. Through the close on 9/16, the S&P 500 has lost 2.1% and the MSCI ACWI has fallen 1.6%,[2] though most major indices remain well in the green quarter-to-date. Seasonality is only one of many factors, however, that are pushing stocks lower as we approach the end of the third quarter. The most important driver continues to be expectations about future Federal Reserve moves and, by extension, data releases that could influence the Fed’s decision making.

Inflation, consumer, and labor market data critical to forecasting the Fed’s next moves were released the week of September 13^th. August CPI was higher than expected at 8.3% in a report that indicated inflationary pressures were becoming more widespread and spreading to services. Services inflation is less correlated to energy prices and supply chains, making it stickier and more difficult to combat. Retail sales were stronger than expected at 0.3% month-over-month in August. The labor market continued to show strength with both initial and continuing jobless claims lower than expected and hovering near record lows. Paradoxically, this good news was not seen as a positive in markets because this strength will allow the Fed to tighten aggressively. The S&P posted its worst daily performance since 2020 following the CPI release and the market now anticipates 75-100 bp in rate hikes at the Fed meeting next week.

Stubbornly high inflation and a growing acceptance that the Fed means business have put pressure on bonds. The Bloomberg Aggregate Bond Index lost another 2.2% so far this quarter on top of a 10.4% loss in the first half of the year. Almost all of these losses have been driven by rate increases rather than a widening of credit spreads that one typically sees during recessions and market selloffs. We remain cautious on credit-sensitive fixed income (ex. high yield, corporate bonds and floating rate loans) for this reason. We are also in the midst of one of the most dramatic yield curve inversions in history with the 2-year Treasury yield of 3.87% significantly above the 10-year Treasury yield of 3.45%. While the shorter end may continue to move higher to price in additional Fed rate increases, the sensitivity of shorter-term bond prices to rate increases is much less than longer-term bonds. Given that, we are finding more opportunities with less downside risk at the shorter end, with higher yields providing a cushion against price declines.

Fixed Income Mutual Funds vs UMA/SMA

We are approaching the final quarter of a year that has already been difficult for bond investors and, with the Fed continuing to hike rates and pare its balance sheet, additional volatility is likely. While we offer both mutual fund and UMA model portfolios to our clients to accommodate a wider range of account sizes, we believe there are clear advantages to investing in individual bonds via a UMA or SMA rather than mutual funds if account minimums can be met.

Bond mutual funds share many similarities with stock mutual funds but are not the same due to the nature of the underlying investments. Stocks tend to be more liquid since most issuers only have one common equity outstanding. Bonds are less liquid since a given issuer can have dozens of different bonds outstanding with varying maturities, yields and terms. Bonds are also issued by non-corporate entities like municipalities and governments, and each adds to market fragmentation. Stocks tend to trade with narrow bid/ask spreads and large quantities can be traded on dark pools without immediate market impact. Bonds, on the other hand, can be vulnerable to air pockets when the price temporarily falls rapidly when multiple market participants must sell at the same time.

A rising rate environment is generally bad for bonds. As an example, imagine you bought a corporate bond in 2020 with a 2% coupon (equal to $20 annually) when the 10-year Treasury yield was only 0.5%. Despite the low coupon rate, the yield was higher than the risk-free rate, so you were willing to pay par ($1000) for the bond. Today, with the 10-year Treasury rate over 3%, that bond is no longer attractive at $1000 with only a 2% coupon. The price will have to fall so that the $20 in annual coupon payments equates to a higher effective yield that is more in line with market rates.

This sensitivity to rising interest rates is directly related to how much time is left before the bond matures. The longer until maturity, the more the price will have to drop to equalize the yield with market rates. If you are a long-term investor planning to hold the bond to maturity, assuming the corporation does not default, these short-term price fluctuations don’t change the fact that you will receive your coupons regularly and your principal back in full at maturity. If the income that was being generated off the bonds was sufficient prior to the rate increase, and interest and principal are reinvested into newer, higher-yielding bonds, the investor does not actually realize a loss.

Unfortunately, this is not the case for investors in bond mutual funds. Unlike an individual bond, a bond mutual fund has no stated maturity or coupon rate. Instead, the portfolio consists of many bonds that are bought and sold when the managers wish to alter the positioning, or when inflows or outflows require it. If redemption requests exceed cash in the portfolio, managers must liquidate bonds to meet the requests. If the issue is market wide, then many funds are likely to experience above-average outflows simultaneously. This forces the fund managers to sell at a time when there may not be many buyers and results in losses for the investors who remain in the fund.

Actively managed bond strategies like the ones we use in our UMA models are not buy-and-hold strategies so there is potential for loss if bonds are sold, but the decision to sell will be based on what is best for the investor. The actions of other investors in the strategy will not have an impact because each investors’ account is separate. Clients with a capital preservation objective who have assets sufficient to meet bond manager minimums could benefit from shifting from a managed mutual fund approach to bond investing to a fixed income SMA, or to a full asset allocation UMA that combines both equity and fixed income managers in a single account.

Disclosure

This document does not constitute advice or a recommendation or offer to sell or a solicitation to deal in any security or financial product. It is provided for information purposes only and on the understanding that the recipient has sufficient knowledge and experience to be able to understand and make their own evaluation of the proposals and services described herein, any risks associated therewith and any related legal, tax, accounting or other material considerations. To the extent that the reader has any questions regarding the applicability of any specific issue discussed above to their specific portfolio or situation, prospective investors are encouraged to contact Gitterman or consult with the professional advisor of their choosing.

Certain information contained herein constitutes “forward-looking statements,” which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue,” or “believe,” or the negatives thereof or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events, results or actual performance may differ materially from those reflected or contemplated in such forward-looking statements. Nothing contained herein may be relied upon as a guarantee, promise, assurance or a representation as to the future.