The US Bond Markets Through a Short Duration Lens

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  • 04 mins 54 secs
In this MFS Asset Class Spotlight, fixed income portfolio manager Alex Mackey shares his views on today's investment grade bond market and thoughts on the challenges and opportunities for bond investors going into 2023.
Channel: MFS Investment Management

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Hi, I'm Alex Mackey, fixed income portfolio manager here at MFS with a quick review of the prior year and a little bit of an outlook for the year to come. 2022 has experienced an aggressive tightening of Fed policy in response to elevated inflation. The year started with a policy rate of 25 basis points and has increased to 4% today.


We expect that rates - the policy rate will continue to rise through the end of 2022 and into 2023. There are a couple of different implications from these actions. One, we've seen the yield curve flatten meaningfully, which is typically a precursor to economic growth slowing, and the prospects for recession, in some ways, it implies that the Fed has acted too late. Two, and it's important to too risky asset pricing and fixed income in particular, rate volatility has been elevated.


Rates have been demonstrating volatility characteristics at levels we haven't seen outside of 2008. And in March of 2020. So there are reasons for caution. We expect this continued tightening on the part of the Fed to persist. We think that the battle against inflation is one that they're dead set on winning, and as a byproduct of that, growth is likely to slow.


And correspondingly, we anticipate that credit fundamentals are likely to deteriorate. As this process evolves, Volatility should evidence itself in markets and we don't believe that volatility has been fully reflected into spreads or the way that risky assets are priced. So those are cautionary aspects of the marketplace. There are, however, a number of reasons for optimism, for thinking about fixed income today.


The first is the starting point of yield. High quality bond yields today are at the highest levels that we've seen since 2009. Yield is an important predictor of expected future returns within fixed income. Another aspect that provides reasons for optimism is the ability to absorb future yield increases. While inflation isn't likely to go away in the very near term and the prospects for the Fed to continue to push rates higher may lead to higher yields, the ability for investors to absorb significant increases in yield is meaningful today.


In particular, if you look at the short duration segment of the fixed income market, breakevens today are approaching 300 basis points, which simply means that investors could tolerate another 300 basis point increase in yields before their return over the next 12 months would approach zero.


We think this gives investors an increased degree of confidence that fixed income can provide ballast that some have called into question more recently. Taking these elements of yield and break evens and starting point of yield as a predictor of future returns together, one area of the fixed income markets that we think offers investors an attractive opportunity today is high quality short duration.


At MFS, we maintain a relatively defensive position within our short term short duration credit strategies, and our approach is historically conservative. We're in a position where we want to be able to actively reallocate risk into a repricing of spreads or how risky assets are valued in the marketplace. And as fundamentals come under pressure, as the Fed continues to push forward with their hiking cycle in their fight against inflation, we anticipate that volatility will assert itself and that spreads will provide us the opportunity to redeploy capital into an active portfolio and take on incremental risk. Valuations today are slightly cheaper than historical long term averages, but if recession is coming, valuations look uncompelling and they're certainly not cheap.


So at MFS, we expect to respond to opportunities across the short duration sectors, and we will focus in on the identified opportunities that our global research platform provides to us. We're much more optimistic about the returns prospects for 2023 as compared to what we've experienced over the course of the past year.

Thank you for your time.

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