At the beginning of the year I wrote a cautious review article on the Western Asset/Claymore Inflation-Linked Opportunities & Income Fund (WOW), warning that a “higher and longer” Federal Reserve could prove to be a headwind for the duration-heavy WIW. funds. I also warned that the WIW fund would likely retest its October 2022 lows, based on the technical situation at the time.
Since my article, the WIW fund has performed poorly, delivering a total return of 4.0% and justifying my caution (Figure 1).
As we close out 2023, let’s review my predictions on the WIW fund and refresh my thesis.
Brief overview of the fund
The Western Asset/Claymore Inflation-Linked Opportunities & Income Fund is a leading closed-end fund (“CEF”) focused on inflation-linked securities with over $600 million in net assets.
WIW’s portfolio currently contains 149 holdings with an effective duration of 8.5 years, essentially unchanged from 8.4 years when I last reviewed the fund (Figure 2).
The fund’s sector allocations have also changed little, with inflation-indexed securities still making up the lion’s share of the portfolio at 79.9% (Figure 3).
The WIW fund pays an attractive distribution of $0.0605/month which cancels out to a yield of 7.1% on net asset value and 8.4% on market price (Figure 4). The WIW distribution is funded by net investment income (“NII”) and realized gains.
“Higher and longer” proved to be a headwind
As I predicted, the Federal Reserve maintained its “higher for longer” message through most of 2023, maintaining tight monetary policy and acting as a headwind for high-duration bond funds like WIW. In fact, the WIW fund reached a low of $7.84 in early October, fulfilling my prediction of a retest of the October 2022 lows (Figure 5).
Fed pivot gives WIW breathing space
However, in recent months, with continued progress on the inflation front, the Federal Reserve has subtly shifted its stance, choosing to keep its key rates unchanged since September and Messaging that policy rate cuts could be considered for 2024. Chairman Powell even said recently that interest rates “would likely be at or near the top rate of this cycle” during his December FOMC press conference.
Looking at the Fed last According to the Summary of Economic Projections (“SEP”), the FOMC committee plans to reduce policy rates from the current level of 5.25% to 5.5% to 4.5% to 4.75% by the end of 2024 (Figure 6).
According to Fed officials, possible policy rate cuts in 2024 are a natural reaction to falling inflation, because if the Fed keeps its policy rates steady while inflation falls, then interest rates real estate prices will increase, which could cause the economy to over-tighten in a recession.
As the Fed officially changed its stance from a “higher for longer” stance to a “soft landing,” markets pushed down long-term interest rates, Treasury yields to 10 years recently falling from almost 5.0% to 3.8% (Figure 7).
As I wrote in my previous article, a “soft landing” scenario could be a goldilocks for the WIW fund, as moderate but still high inflation keeps interest payments high on the portfolio. WIW’s investment as lower long-term interest rates boost WIW’s long-term assets. Since the end of October, the WIW fund has rebounded by 7.5% (Figure 8).
Short-term overbought bonds
In the short term, traders may have become too aggressive, with Fed Funds futures now expecting the Federal Reserve to cut policy rates 6-7 times in 2024, up from the estimate of 3 cuts by Fed officials (Figure 9).
However, the Fed’s shift in stance is undeniable and should provide a boost to long-duration assets over the coming year, provided inflation does not make a surprise comeback.
Inflation is the wild card
So far, headline CPI inflation has fallen nicely, trending toward a 3.1% year-over-year rate in November and in line with the Fed’s 2% target at the end of 2024. However, the The stricter core CPI measure has been much harder to reduce, with the latter remaining stubbornly high at 4.0% year-on-year (Figure 10).
Judging by underlying CPI, the Federal Reserve may be premature in declaring victory and changing its stance, since financial conditions Interest rates have eased to early 2022 levels due to the Fed’s accommodative turn (graph 11).
The risk is that easing financial conditions could reignite “animal spirits” and create a second wave of inflation in 2024, undermining the “soft landing” narrative and forcing the Fed to restart rate hikes. key rates.
We’re already seeing signs of froth, with cryptocurrencies hitting new 52-week highs and unprofitable concept stocks staging impressive year-end rallies. Bond investors should closely monitor financial conditions and inflation indices to ensure that inflation does not return, which would require additional monetary policy measures to address.
With the Fed recently adopting a “soft landing” policy and moving toward rate cuts in 2024, I think long-duration bond funds like WIW should benefit. Even though bonds are overbought in the short term, monetary policy tailwinds are undeniably supportive.
The current scenario of a “soft landing” could be a goldilocks for the WIW fund, as moderate but still high inflation keeps WIW’s interest income high, while falling interest rates Long-term interest generates capital gains.
The main risk for the WIW fund and for bond investors in general is if the Federal Reserve declares victory prematurely, easing financial conditions too soon and allowing inflation to return in 2024. If that happens, we could regret the current bond respite, because it will require additional monetary policy measures to be taken, beyond what has already been adopted.
I am raising the WIW fund at a buy for 2024.