Why the Fed’s Bond Runoff Might Not Be Such a Big Deal

Will the Federal Reserve’s great bond runoff not amount to much?

Moderation was the watchword for the Fed as it announced its tightening regimen Wednesday. At the news that the federal funds rate would rise by only 0.5 percentage points—instead of the rumored 0.75—the stock market responded euphorically, though it gave back the gain this morning.

Meanwhile, bond yields didn’t move much. Why? One explanation: The amounts the Fed aims to trim from its swollen balance sheet—now standing at $8.9 trillion—were well-telegraphed, and Fed Chair Jerome Powell confirmed it yesterday. No one can be sure how much the Fed will boost the federal funds rate, but the balance sheet shrinkage appears less ambitious. That might remove some upward pressure for long-term rates.

When the pandemic hit, the Fed doubled the amount of Treasury bonds and agency mortgage-backed securities it held, buying gobs of them to lower long-term yields and thus make borrowing cheaper in a shocked 2020 economy. The Fed had done that once before, in response to the 2008 financial crisis. In 2018, when it tried to reverse the process and shrink the balance sheet, a political firestorm erupted, and it backed off.

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Reducing the central bank’s bond holdings has “only happened one other time, and the Fed didn’t get too far before having to reverse course,” LPL Financial’s fixed-income strategist, Lawrence Gillum, has observed. “This time will go more smoothly.”

Powell said that the bond runoff will start in June, and left open how long it would run. For the first three months, it will allow $30 billion in Treasury bonds and $17.5 billion of agency mortgage-backed securities to mature each month, instead of rolling them over. After that, the pace will increase to $60 billion in Treasury bonds and $35 billion in MBS, or $95 billion per month.

That means a little more than $522 billion will leave the Fed balance sheet this year, bringing the total Fed bond holdings to $8.4 trillion at year-end. At a $95 billion monthly runoff rate going forward, it would take the Fed four years to return to the pre-pandemic balance sheet level of $4.2 trillion.

Long-term Treasury yields have been increasing, although hardly at a torrid tempo. The benchmark 10-year note is up just 1.3 percentage points this year, to a bit over 2.9%.

Both the stock and bond markets are in the dumps, a major bummer for investors. The S&P 500 is down this year by 9.8% and the Bloomberg U.S. Aggregate Bond Index is off by an almost identical 9.9%.

Typically, when stock prices go down, bond prices go up. But the Federal Reserve’s rate-hike plans have thwarted that neat little dynamic, leaving investors scrambling. So J.P. Morgan’s U.S. high-grade strategist, Nathaniel Rosenbaum, and his team have concocted a strategy to try getting around this problem.

When bonds had lower yields, some investors sought to make up the difference by buying high-dividend stocks from solid companies. Because the stock market was booming then, this tactic had a double advantage: investors could earn decent income while their shares appreciated. Those days are over, obviously.

Now, JPM’s idea is to stay with the same trustworthy companies but swap the companies’ stocks for their bonds, which are yielding better lately as rates climb. The thinking is that the bond prices won’t fall too much—what JPM calls “downside protection”—and the payouts will be even better than before.

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As the JPM report puts it, “when yields were low, investors occasionally looked to high dividend paying equities as yield with growth upside. Fast forward to today and one can effectively make the reverse argument.”

JPM screened for quality investment-grade bonds that significantly outyielded their equities, from companies whose stocks paid dividends of above 3%. Another requirement: The stocks must be up year-to-date, which says something about resilience in 2022’s lousy market. “Protecting these gains by rolling into HG bonds may be advantageous in certain cases,” the study says, referring to “high-grade” paper.

Helpfully, JPM has a list of these worthy investments. The 66-name roster contains companies that include energy, pharma, health, utilities, real estate, consumer goods, and media.

First on the list is Paramount Global, formerly ViacomCBS, up 1% this year. It had been higher until recently, but revenue fell short of analysts’ estimate for its most recent quarter and the stock dipped. Nonetheless, the company’s 3.2% dividend yield is overshadowed by its bond yield, 5.9%.

No. 2, Kohl’s, the department store chain, has held up fairly well in the pandemic, with the help of a partnership with Amazon. Takeover talk has helped spur the stock, with the latest suitor being rival JCPenney. But even before the merger excitement, the stock has done well for some time. The stock is up 20% this year, with a 3.4% dividend yield and a 5.9% bond yield.

NiSource, a public utility and the third company on the JPM list, has similar comparative metrics: 3.3% and 5.6%. The stock is ahead 6% in 2022.

Following these picks are medicine maker Bayer, American Electrical Power, Kilroy Realty, and Cardinal Health.