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Securities in This Article Baird Core Plus Bond Inst (BCOIX)
Baird Aggregate Bond Inst (BAGIX)
Baird Intermediate Bond Inst (BIMIX)
Baird Ultra Short Bond Institutional (BUBIX)
With concerns about inflation and growing deficits, bond yields have been creeping up. Still, a pair of top bond fund managers say the current landscape presents both opportunity and cause for concern. We checked in with Baird Advisors’ Mary Ellen Stanek and Warren Pierson, who are among the co-managers of the Gold-rated Baird Aggregate Bond Fund BAGIX. Stanek, who co-founded Baird, won Morningstar’s 2022 Outstanding Portfolio Manager award, and Pierson is the firm’s co-CIO.The pair believes current yields look attractive. Though much rides on a resolution to the Iran war, they say bond yields are unlikely to move much higher. Their bullishness isn’t universal; they are wary of the AI-spawned flood of data center debt hitting the corporate bond market, and there are a few key areas they’re steering away from. Read on for their insights.Leslie Norton: Yields are up, and the Iran war hasn’t ended. What’s a bond investor to do?Mary Ellen Stanek: There’s good value in bonds where they are, and while spreads are tight, nominal yields are actually quite attractive, and you don’t have to go all that far out. The intermediate part of the curve, in particular, offers pretty good value. There’s a lot of uncertainty, a lot of complexity in the environment. We manage the portfolios towards quality. We maintain a lot of liquidity, both for the investor and ourselves. If the markets are dislocated, we want to take advantage of that.Warren Pierson: Yields are a lot more attractive than four years ago. Investors have been demonstrating their interest in the market with strong industry flows into mutual funds, ETFs, and annuities. Some of the go-anywhere investors, like hedge funds, may shy away because the rise in interest rates may have a detrimental effect on short-term returns. That’s not the bulk of the [investors in the bond] market.Norton: How high will yields go in the near-to-intermediate future? What’s the chance of the 10-year reaching 5% or higher?Pierson: We wouldn’t expect a dramatic change from where we are. For the 10-year, 4%-5%. Right now it’s 4.48%. If inflation looks like it’s got some staying power, if [the war] doesn’t get resolved and oil stays where it is, that’s gonna have a ripple effect. Certainly, oil at $100 a barrel will have an inflationary impact. If there’s more concern about the deficit, that could put upward pressure on yields. But so much money is coming into the market that it should keep yields from rising dramatically.Stanek: The good news is that from the investor’s vantage point, you’re earning higher yields for a longer period of time, which gives you a cushion and a buffer.Norton: Let’s have some color on those higher yields.Pierson: The yield on the Baird Core Plus Bond fund BCOIX, which goes across the entire yield curve, is just below 5%. On the aggregate fund, it’s 4.82%. On Baird Intermediate Bond BIMIX, it’s 4.5%.Stanek: For Baird Ultra Short Bond BUBIX and shorter, the trailing annualized total returns are in the 5% range for the three-year period. They’ve been slightly higher than our full market funds because yields rose over that period. We didn’t try to time anything by moving duration around. We’ve just been disciplined in terms of managing risk carefully.Right now, we’re in a 28-year tightness in credit spreads. The most likely causes of a widening of credit spreads going forward from here would be a deterioration of credit fundamentals, the likely result of a much weaker economy, and/or a significant reduction in the amount of money flowing into the bond market. We’ve lived through tight spread environments before. The thing we keep saying is “Stay disciplined, stay focused, don’t stretch.” Because from a valuation management point, you often regret it.Norton: How does this fit into the larger story of higher yields in Japan, the United Kingdom, and Europe?Pierson: This isn’t just an American story. Across the globe, you’re seeing interest rates up, especially compared to three to four years ago. All the developed nations have put a lot of debt on their balance sheets. The markets will be pretty patient with the United States, but we need to start showing some progress. So far, we haven’t.Now, are rates historically high? People think 7% mortgage rates are awful. My first mortgage was 11% or 12%. We have a Baby Boom generation that’s retiring and saving. Higher interest rates look pretty good to a lot of those people. Those who aren’t borrowing like the higher interest rates.Is the oil shock behind us? That all depends on whether Iran is willing to come up with a settlement where they’ll allow the Strait of Hormuz to be open. But if oil stays up where it is, that will cause inflation to have a little bit more sting.Norton: Let’s talk about your longer-term concerns and outlook.Stanek: Neither side is interested in reining in the deficit. Meanwhile, the cost to service that debt keeps going up. It potentially crowds out other uses for that fiscal spend. Decent yields for a longer period are giving investors some protection. We haven’t even touched on the domestic potential volatility around uncertainty about congressional elections.You have an economy that is complex, but the big surprise is its momentum. Earnings are good, and productivity seems to be rising. It does appear very concentrated on the buildout in the data center world. But ultimately, it’s an OK economy.When you look under the headline numbers and slice it by demographic, you get some very different views, which is probably one reason that consumer confidence and some consumer indicators are flashing caution. I filled up my car last night for $62. It used to be $40-something. I shrugged and drove away. But how many people must make other choices about their marginal spending?The range of possible outcomes is quite high. You could make an argument for a really tough environment depending on a set of geopolitical events, or just the opposite, and both scenarios would be fairly plausible.Norton: What about the disruptive force of AI? What does it mean for the economy?Stanek: Overall, AI is a productivity lift. The jury’s out on how much it will replace labor. So the price of labor is probably lower than otherwise because labor wants to hold on to their job. They don’t necessarily want to demand much bigger annual increases. Our investment team is trying to sort through it. It makes our specialized talent potentially more productive. Securitization deal documents can be 70 pages long. There’s a tsunami of information. We are watching the use cases carefully. Employers are cautious about adding workers on the entry-level side, in IT-related jobs. In other sectors, there’s still a lot of demand. Will it ever replace our experienced analysts? No, because you still need somebody who can look at the output and can discern value. At the margin, it’s keeping labor rates lower than they otherwise would be, given the inflation shock that we’ve endured in the last three months.Norton: Where should investors be cautious?Pierson: When they go outside their normal risk parameters, way out on the yield curve. The yield curve has flattened this year. Coming into the year, people thought the Fed would cut rates twice, so short yields were lower. Now, short yields have come up a bit. Concerns about the deficit probably put some upward pressure on long rates, so our best guess is that you probably see some steepening of the curve.We look at the difference between nominal Treasury yields and TIPS yields. That’s been pretty tame. On the long end, expectations are 2.25% inflation, and in the two-year range, the difference says implied inflation is 2.6%. Now, when the war broke out, on the short end, expectations went up to 3.2%. But it’s nothing like the consumer confidence or University of Michigan surveys, which have shown expected inflation rates of 4%, 5%, 6%. The market is saying inflation isn’t a big deal over the long term.The higher yields, too, present a headwind to a lot of other sectors—real estate, private equity, private debt. Four years ago, when interest rates were basically zero, that was a tailwind for these sectors. Now, people are looking at public investment-grade fixed income and think, “I’ve got yields close to 5% and liquidity? That looks pretty good.”Norton: What are you avoiding in the market today?Stanek: Will we need all the capacity being added in the data-center buildout? It’s unprecedented. What if some of it is mothballed or potentially repurposed? What are the potential use cases? Pat Brown, one of our co-leads on securitization, notes that it’s a single asset, a single borrower. In the last recession, commercial real estate was slow to repurpose. The debt can be 10-plus years, most of it is non-amortizing, so when it comes due in 10 years, what happens if you don’t need all of that capacity?Pierson: We’ve been pretty cautious. We don’t feel that those yields are adequately paying investors, although [data center issues] are going into the [bond] indexes. If over time their spreads widen, we’d be more interested.Norton: What do you like?Pierson: We’re overweight in investment-grade credit. We see value in the two-to-seven-year, and we’re underweight longer credit. When credit spreads are historically tight, if they widen over time, then taking that exposure shorter on the yield curve will give you a lot better protection.Our yield advantages over the benchmarks are smaller than they’ve been historically. In the securitized sector, we’re underweight agency mortgages, Fannie Mae, Freddie Mac. We think intermediate treasuries on a total return basis could probably outperform mortgages over the coming 12 months. We see some decent value in some of the [Commercial Mortgage-Backed Securities], and we’re staying in the most senior-rated AAA, looking for 30% credit enhancement.Norton: Can you be more specific?Pierson: We’re overweight in the finance sector, banks in particular. Banks are well capitalized, they’re in good shape, a lot of the issuance is inside of 10 years. Spreads on financial issues are still a little wider than on industrials, but historically, those financial spreads go inside the industrial sector. There’s a good chance that could happen.Norton: What about municipals?Pierson: That yield curve is steeper than the Treasury curve. There’s better value in the long end, maybe 10-15-year, but not 30-year. You measure that attractiveness by comparing, say, an AAA municipal yield to Treasury yields. The shorter you go on the curve, the less attractive those ratios. Going back to the deficit, it’s interesting to hear politicians coming up to the midterms and to a presidential election, talking about tax cuts. Folks, be real. We’ve got a $2 trillion annual deficit. I don’t think we’re going to see tax cuts. You could see federal income tax rates even go up a bit. When you roll all that together, municipal credit is in pretty good shape.Norton: Anything else?Pierson: We just don’t think investors should be over their skis. You’re just not paid to take a lot of risk. Yields are attractive; it’s primarily the level of interest rates, so don’t go too far out the curve, don’t go too far down in quality, and you [end up with] a good quality investment portfolio that’s giving you a pretty attractive yield. The author or authors do not own shares in any securities mentioned in this article.
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