by Bryan Perry

November 8, 2022

The latest catch phrase coming from last week’s Fedspeak is “the terminal rate,” or the level at which the Fed is expected to stop raising interest rates. With last Wednesday’s expected 0.75% hike, the Fed funds target rate range is now 3.75% to 4%. At first, stocks rallied sharply, then fell during the presser, but stocks rallied again late Friday after investors heard from Boston Fed President, Dr. Susan M. Collins (an FOMC voting member) saying that she supports smaller rate hikes going forward, followed by holding the Fed funds rate range at a restrictive level, while Chicago Fed President Charles L. Evans (a non-voting member) said that it makes sense to shift to smaller rate hikes soon. (On a confirming note, JPMorgan expects a 50-basis-point rate hike in December, followed by a 25-bp hike in February.)

The latest CME FedWatch Tool shows a 52% probability for a 50-bp rate hike at the December 14 FOMC meeting and a nearly equal 48% chance of a fifth 75-bp hike then. The larger hike would take the Fed funds rate up to 4.50%-4.75%. These estimates will likely shift radically over the next few weeks as the next batch of economic data crosses the tape. What it does show, though, is that the Fed dared to act aggressively right in front of the highly charged mid-term elections, sending a clear message that they are on “high inflation alert,” where they feel that further aggressive action in the form of rate hikes and quantitative tightening to the tune of $95 billion per month is essential to breaking inflation’s back.

Target Rate Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Since the market is a forward discounting mechanism, the terminal rate will likely end up being 5.00%-5.25%, requiring further action in February, so now is probably a good time to start considering some fixed income assets and bond equivalents, even if the terminal rate stays at an elevated level for several months. That’s because the same problems that ignited inflation are pretty much still in place – increases in wages, salaries, food, energy, rents, and professional services. The cost to travel is extremely high and there remain key supply chain bottlenecks that continue to add to the cost of certain goods in transit.

Assuming inflation pressures are relieved somewhat in the coming months, with the overall rate coming down to the 5%-6% range, the bond market will be basically meeting inflation where it now is, representing a sense of equilibrium that should be constructive for equities and certainly an opportunity for income investors to lock in some juicy rates that are consistent with the rate of inflation.

Depending on one’s view of whether the U.S. economy will experience a soft or hard landing, for the first time in a long while, government bond yields and other fixed income assets have offered investors rates that could make them stop and think about putting their cash to work in risk assets.

US Treasury Table

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

From the table above, the 2/10 Treasury spread is at roughly 50 bps (4.658 – 4.163 = 0.495), implying a material slowdown in GDP during 2023. With any whiff of receding inflation, this spread will narrow sharply, with the yield curve flattening, hopefully followed by normalization, where long-term rates are higher by 30-50 bps over short-term rates. But a lot of constructive data has to occur before this transition can take place, and this window of a terminal rate scenario that has severely punished Treasuries, corporate bonds, municipal bonds, convertible bonds, preferred stocks, REITs, and utilities may close sooner than expected if the market decides peak inflation and peak rates are a product of Q1 2023.

Taking into account a few ETFs and closed-end funds that trade at huge discounts to Net Asset Value (NAV), I would contend that the time is now to lock in some yields, with the understanding that the cycle of rate hikes is nearing completion. If so, here are some examples of what investors can look at for yields:

Nuveen AMT-Free Quality Municipal Fund (NEA) is a national portfolio trading at an 11.9% discount to NAV, sporting a 5.2% distribution yield that pays monthly, with just over 90% of the holdings being investment grade. This fund utilizes leverage to reach such an attractive yield.

Nuveen Fund Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Shares of NEA are trading 35% below their high. If you add in the nearly 12% discount to NAV, we’re talking about a 45% correction from peak to what may be the trough. For income earners in the highest tax bracket, the yield has a taxable equivalent rate of over 10%.

iShares Preferred & Income Securities ETF (PFF) is more appropriate for retirement accounts or those who want something outside the municipal market. It pays out a current yield of 5.6% and trades 24% below its multi-year high and pays monthly.

US ETF Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

For a pure play on the investment grade corporate market, the iShares Investment Grade Corporate Bond ETF (LQD) sports a 5.8% distribution yield, an average yield to maturity of 5.95%, an average weighted maturity of 13.5 years, and a portfolio effective duration of 8.2 years. After peaking in 2020 at $140, shares of LQD are currently trading at $101, or nearly 28% below that high.

Invest Grade Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

If the Fed does in fact pivot in the next year to lower rates, these three assets and many others of similar nature will be big winners. For those savvy enough to shop for individual bonds, preferred shares, convertibles, and Treasuries, constructing a custom portfolio reduces the risk of ETF funds having to buy bonds with lower yields, as prices are rising when capital flows surge back into these asset classes. Just screen for the top holdings of each and build a portfolio that isn’t compromised by outside fund flows.

It is a tricky feat of timing to call for a terminal rate for Fed Funds, or a bottom in bond prices, but the time is near for income investors to be thinking about allocating capital back into fixed income if the forward data proves to support the case for peak inflation.

All content above represents the opinion of Bryan Perry of Navellier & Associates, Inc.

Please see important disclosures below.

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The Fed’s Epic Bait and Switch

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Is Carefree Investing Possible in This “Age of Anxiety”?

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About The Author

Bryan Perry

Bryan Perry

Bryan Perry is a Senior Director with Navellier Private Client Group, advising and facilitating high net worth investors in the pursuit of their financial goals.

Bryan’s financial services career spanning the past three decades includes over 20 years of wealth management experience with Wall Street firms that include Bear Stearns, Lehman Brothers and Paine Webber, working with both retail and institutional clients. Bryan earned a B.A. in Political Science from Virginia Polytechnic Institute & State University and currently holds a Series 65 license. All content of “Income Mail” represents the opinion of Bryan Perry

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