Baird Advisors held its annual Institutional Investors Conference on September 8 in Kohler, Wis., where this year the firm celebrated both the 25th anniversary of the conference and the Baird Funds. In addition, Co-CIO Warren Pierson provided the firm’s annual market assessment and investment outlook. Following is a summary of Pierson’s remarks:
Investment Outlook
While the last 12 months were profoundly shaped by the incoming Trump administration’s DOGE program, tariffs, immigration and foreign policy, what hasn't changed over the last year is that the bond market still represents good value despite policy initiatives that cloud the outlook: “We think the Fed is poised to ease, given weak employment reports,” Pierson said. “Tariffs will likely lead to slower growth and higher inflation. Immigration policy on top of a labor shortage will add to wage pressure. Add a changing global order and America's role in that adds to uncertainty.”
That uncertainty has created a fair amount of volatility. Several forces pushing rates down include strong flows into bonds and signs of slower growth. This is offset by heavy Treasury supply, rising deficits, risks of stagflation or inflation and uncertain global capital flows.
One year ago, Pierson told attendees he thought bonds offered good value and that proved to be the case, as one year returns on bonds have been solid, and yields remain attractive. “Our relative results over the last year have been close to benchmark on a net basis. While we had larger relative outperformance in 2023 and 2024, we are happy to be close to our benchmarks given the tight spreads we are seeing.” Pierson added that strong fixed income inflows, including flows into annuities, are further evidence of the value offered by bonds.
Finding value in a curve-steepening scenario
A major theme Pierson expects going forward is yield curve steepening. “Short rates have come down, but it is unclear what will happen across the yield curve. There is a focus on the long end of the curve, and concerns about the deficit are putting upward pressure on rates.” While the curve has steepened 130 basis points, it is still flatter than the historical average. “We think there will likely be more steepening.”
As to where to find the best value on the curve, Pierson advised, “Don't be too short and maybe don't be too long. There is really good value in the middle. Not only are nominal yields attractive, but more importantly, real yields are positive. These yields are more attractive than they've been at any time in the post financial crisis period. And investors are taking notice that they are beating inflation.”
Spreads remain tight with the option adjust spread (the yield spread over Treasuries for taking credit risk) at a relative low. Investment grade corporates are now only 79 basis points over Treasuries. Pierson noted this is near the tightest spread in 25 years. The average for investment grade spreads has been 119 basis points over the last 10 years.
While corporate bond spreads are tight, Pierson said they are supported by the fundamentals. “We've seen some softening, but by all measures–revenue, profits, free cash flow, cash on the balance sheet—fundamentals are at historically sound levels.
We think tight corporate spreads could be with us for a while.” Pierson pointed to past cycles, the late 1990s and mid-2000s, when spreads tightened and stayed there for an extended period.
Yield buyers continue to support tight spreads. While Baird employs a relative strategy that looks to beat benchmarks, there are many investors today-- Pierson pointed to annuity issuers and corporate pension plans as two examples--that are less focused on relative returns. “If you are seeking a 6% total return in a diversified portfolio and can get 5% from your high-quality bond allocation, then you are a buyer.”
Investors wanting long exposure can really only find it in the US where there continues to be significant supply. Gross investment grade corporate issuance this year is down only about 1% from last year. However, net issuance (total bond issuance minus bonds that have matured) is down 36%. Pierson believes this is healthy as some companies let debt roll off instead of issuing bonds at higher rates. “There has been concern that companies wouldn't be able to refinance that debt when rates got higher. But the truth is they aren't refinancing everything.”
Economic challenges
Pierson flagged a number of risks for the economy and financial markets.
While the Fed has made progress on fighting inflation, tariffs cloud the picture. “Our sense is we have not yet seen the full impact of tariffs. Prices could drift higher. Longer term we're still constructive on inflation, but there could be some challenges in the near term.”
Meanwhile, consumer balance sheets are in good shape, but housing for many is less affordable, especially for young people. Of particular concern is the wealth gap, with asset prices driving the disparity. “If you have a portfolio and own a home, you’re doing well, But wages haven't kept pace with inflation, and a big portion of the population is feeling the pinch.”
The labor market has softened with unemployment above 4% and non-farm payrolls weakening, especially after downward revisions. Weak employment is particularly prevalent among younger workers. They faced an 8% unemployment rate in 2024. “Our sense is AI may be contributing to this, and employers remain cautious.”
Another challenge for economic growth Pierson highlighted is immigration. After several years at higher levels, immigration has fallen off, and a smaller labor force creates challenges. Projected growth in the labor force is already low due to demographics. “If we expect to grow the economy, it will have to come from productivity. This is a hard measure to predict and get right, and it isn’t clear whether AI will help. Growth will be a challenge for this economy.”
Fed balance sheet and the deficit
The Fed's balance sheet is shrinking. Good news in Pierson’s view. It topped out at $9 trillion a few years ago and now is below $7 trillion and coming down as a percentage of GDP. However, Pierson doesn’t expect continued shrinkage: “The Treasury may shift some issuance to the short end of the curve, and we may get some help from the Fed in the form of lower short-term rates that reduce bowering costs. But the Fed could use its balance sheet again to absorb some of that supply.”
The deficit is still a key concern given interest costs. Treasury debt as a percentage of GDP is the highest it has been since World War II, with more than half of it maturing in the next three years. “Rolling over at lower rates could provide some interim relief, but the debt burden will be a hinderance to long term growth and is on an unsustainable path. Expected costs for Social Security, Medicare and interest on the debt will nearly double by 2035. We are handing the next generation a huge debt burden instead of the legacy of growth we were given.”
Positioned for the unexpected
Despite the deficit and the litany of question marks hanging over the economy, Pierson believes the bond market represents good value, and his team is conservatively positioned. While portfolios are overweight corporate credit and the securitized sector, that exposure is on the shorter end of the yield curve. “With Treasury exposure at about 30%, we have a lot of dry powder. We aren't just thinking about yield, we are thinking about liquidity. And if we do see spreads widen, we are well positioned to take advantage of that.”
Tight credit spreads and equities at near record levels reflect optimism that Pierson said is underpinned by strong earnings, tax cuts, deregulation and favorable technicals. But he remains cautious, as the risk of a negative surprise is elevated. “The risk return balance isn't as attractive as it can be. A lot could go wrong, and the market is priced for perfection. “Bond yields could rise further even if the Fed resumes rate cuts. Fiscal sustainability and concerns about the deficit could continue to rise. Attacks on the Fed’s independence and the administration's ‘flood the zone’ policies could create a negative surprise. Throw in a little bit of geopolitical risk, and things might not go right. So we want to remain conservatively positioned, mindful that there is still value in the market, but it just isn't an environment where you want to add risk exposure.”
In the municipal market, Pierson noted yields are highly attractive on a tax adjusted basis. Underperformance in the market earlier this year means that municipal bonds are cheap. “A steeper yield curve has led to investors extending maturities, and we think 15 to 20 years may be the sweet spot right now. The muni market has lagged the taxable market, and we think there is a lot of value in the muni market now.”
Pierson noted that the team’s views on the market have garnered national attention and recognition including a recent Barron’s Q&A on the New Allure of Municipal Bonds.
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