Fixed Income Outlook: More Yield to Be Had
Views on duration, return of real yield, and opportunities and risks late in the credit cycle are shared by our fixed income managers.
A Different Credit Cycle
Elaine Stokes: This is a different credit cycle than what we’ve seen in the last few years, with fundamentals for this late stage appearing solid. We’re seeing unique characteristics with companies being disciplined, not as overextended as you might expect at this point in the cycle, with leverage and interest coverage looking good. Given that, we expect to see low losses, which translates to an attractive market for fixed income.
Peter Palfrey: We could see upcoming opportunity to capture higher incremental yield, given that we have a strong base starting point, but also price appreciation potential through lower rates as the Fed perhaps reverses some of the tightening they've implemented over the past year plus. In our view, we may see lower yields overall. And we should get through some kind of modest economic downturn, which could open up the opportunity for a renewed skew toward risk securities.
Will Interest Rates Hold?
Adam Abbas: Our prediction for some time has been that they will remain at current levels through 2023, contrary to market expectations of cuts this fall, which we don’t foresee given current indicators. We do, however, foresee promising signs of inflation decelerating further by year end.
High Yield or Investment Grade as we Move Through the Cycle?
Todd Vandam: In our experience moving from late cycle to downturn, you typically want to be up in quality and carry more investment-grade securities relative to high yield. And as the cycle moves to downturn and recovery, you want to reverse that process. You want to ensure: 1) your investment grade securities are not going to get downgraded to high yield in a slower economy or recession, and 2) investments are liquid, so you have the ability to sell and redeploy them into the high yield market when the opportunity arises.
Potential Fixed Income Opportunities Outside of the US
Matt Eagan: The dollar has been very strong structurally due to the yield advantage it’s provided, and relative growth versus what we’ve seen globally. Some of those factors are starting to change and we’re beginning to look outside the US for opportunities, though we think it could be too soon to bite too much into those areas.
Peter Palfrey: Both the Mexican peso and Uruguayan peso are interesting opportunities and have appreciated sharply last year and again this year. This year, we see strong appreciation on the currency side as well as incremental yield from owning their government bonds denominated locally in Uruguayan and Mexican peso.
Fixed Income in the US
Abbas: We like the non-agency securitized space, with certain subsectors, like ABS, pricing in a much worse outcome for the economy versus benchmark indices, like corporate credit and investment grade, and investment in high yield corporate credit.
Elaine Stokes: The securitized market offers nice excess yield, giving a liquidity premium, as well as a bit of premium, especially given recent commercial real estate issues. Beyond commercial real estate, we see opportunity for excess yield, via a diversified selection of securitized credits, where we hope to benefit by doing the research work and really understanding the structures.
Add Duration at the End of Hiking Cycles?
Adam Abbas: The end of hike cycles has historically been a great time to add duration as evidenced by analyzing data in 1994, 1999 – 2000, 2004 – 2006, and 2017 – 2018. At the end of the hike cycle, medium to longer duration US Treasury, in our view, is the best risk-adjusted asset class in the following two years. It’s easy to get trapped into just wanting to buy the front end when you have a curve inversion – but we believe we are at max reinvestment risk today.
Peter Palfrey: We believe the kind of duration you have is important and, in our view, the key is to have high-quality duration when you feel you're likely heading into some kind of economic downturn.
Banking Sector and Geopolitical Risks
Matt Eagan: We’re watching the US banking sector, along with other parts of the market, where balance sheets are shrinking and deposits leaving for higher-yielding alternatives like money markets. That type of credit crunch could lead to downside on the economic front. We’re also watching geopolitics and still see tension between the US and China impacting the macro backdrop and, of course, what’s going on in Ukraine.
All investing involves risk, including the risk of loss. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.
Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise, bond prices usually fall), inflation and liquidity.
Below investment grade fixed income securities may be subject to greater risks (including the risk of default) than other fixed income securities.
Credit quality reflects the highest credit rating assigned to individual holdings of the Fund among Moody’s, S&P, or Fitch; ratings are subject to change. The fund’s shares are not rated by any rating agency and no credit rating for fund shares is implied. Bond credit ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest).
Interest rate risk is a major risk to all bondholders. As rates rise, existing bonds that offer a lower rate of return decline in value because newly issued bonds that pay higher rates are more attractive to investors.
Liquidity risk exists when particular investments are difficult to purchase or sell, possibly preventing the sale of these illiquid securities at an advantageous price or time. A lack of liquidity also may cause the value of investments to decline.
Mortgage-related and asset-backed securities (ABS) are subject to the risks of the mortgages and assets underlying the securities. Other related risks include prepayment risk, which is the risk that the securities may be prepaid, potentially resulting in the reinvestment of the prepaid amounts into securities with lower yields.
Foreign and emerging market securities may be subject to greater political, economic, environmental, credit, currency and information risks. Foreign securities may be subject to higher volatility than US securities, due to varying degrees of regulation and limited liquidity. These risks are magnified in emerging markets.