Fixed Income Portfolios: Time to Build a Yield Advantage

Efforts by global central banks to remove liquidity from the financial system to combat inflation in 2022 caused a lot of pain for investors, says Brian Kennedy, Fixed Income Manager on Loomis, Sayles & Company’s Full Discretion Team. But he points out the good news is fixed income markets have yield once again. In this January 2023 interview, Kennedy shares his views on the macro landscape, potential investment opportunities, and how the team is building a yield advantage back into portfolios.

How Might the Fed Move in 2023?
As far as the Fed is concerned, we’re likely closer to the end of the rate-hiking path than we are to the beginning. The markets are getting very aggressive again and almost pricing in deflation at this point. If you look at one-year inflation break-evens, they’re actually below 2%. We believe the Fed has 50 to 75 basis points more in this first quarter of 2023 hiking cycle before it pauses. That likely puts the Fed rate in the 5% to 5.25% range. Also, we think that any economic slowdown in the US is likely to be mild enough that it’s not going to cause the Fed to turn around and cut interest rates immediately.

We still believe inflation is likely to stay above 2%. That’s largely because of secular dynamics that are in place within the labor markets, as well as the geopolitical relationships around the world, ESG considerations, and some of the sovereign borrowing needs going forward. Another portfolio manager on the Full Discretion team, Matt Eagan, has summarized it as the “four Ds” – demographics, deglobalization, decarbonization, and deficits.

Is the Global Picture Similar?
We may see inflation peak in Europe as well. Certainly, the warm weather in Europe so far has helped the challenge of heating homes, businesses, and factories with natural gas. But the energy situation related to the Russia-Ukraine war remains tenuous. So I think it’s much more likely that you’re going to see a more significant recession in Europe than you’re going to see in the US.

China remains the only major central bank that’s relaxing monetary policy and making efforts towards stimulating its economy. And you can see that in some of the efforts with homebuilders and property developers. Certainly, the removal of the zero-Covid policy is going to boost economic activity in China over time. And that should be good for Asian economies. It’s also good for some currencies.

Where Are We in the Credit Cycle?
We think we’re still in the later stages of this late expansion phase. We call it late cycle. Certainly, the next stage of a cycle would be downturn. So we are being prudent about the risk that we’re taking. We are also sitting on historically elevated levels of reserves, so if we did see a market drawdown, we would take advantage of opportunities in the markets when they present themselves.

Overall, we’re coming off a really strong base of economic performance over the past two years, both ’21 and ’22. The US consumer and corporate balance sheets are strong as we enter this slowdown. But from a cycle perspective, we are starting to see signs of the slowdown. Profit margins are contracting, pricing power is starting to abate for some companies, and debt to profit ratios are growing. Also, senior loan officer surveys are showing tighter lending standards across the board.

Considering Your Macro Views, What Are Some Interesting Areas Today?
Well, the Full Discretion team incorporates six pillars of security selection into the investment process – Fallen Angels, Cheap for Rating, Upgrade Candidates, Stressed/Distressed, Avoid Losers, and New Issue Premium. Among them, there’s a couple that stand out. Certainly, “New Issue Premium” right now is interesting. We’ve had a deluge of new issues, specifically in the investment grade market, to start the year off.

Fallen Angel: Forced selling by investment grade accounts pushes bonds below fair value and inflates risk premium.

Cheap for Rating: Bonds trading cheap to fundamental credit risk tend to outperform.

Upgrade Candidates: The market is often slow to price potential upgrades due to short time horizons and distortions created by passive investing.

Stressed/Distressed: In our experience, prices for the lowest quality bonds become severely dislocated when the distressed ratio is elevated.

Avoid Losers: Avoiding permanent principal losses associated with value traps can add significant alpha.

New Issue Premium: New issues often come at a premium in order to attract investors to the primary market.

“Cheap for Rating” is another pillar where we see interesting ideas. One example is US banks. They are very well capitalized at this point. Maybe at no other time in history have they been better capitalized coming into an economic downturn. But they are trading historically cheap to their ratings.

Then, as we come to the end of a cycle, sometimes having the opportunity to miss out on a loser, or “Avoid Losers,” can be beneficial to the investment portfolio as well. So we think there’s going to be some surprises here, most likely on the negative side as we see earnings revisions. Also, we see companies may be challenged from an inventory standpoint or a profit margin standpoint. Therefore, avoiding losers is important at this time. Sometimes it’s not what you put into the portfolio, but rather what you don’t put into the portfolio that can help you at this stage of the cycle.

On deck – “Fallen Angels.” We are going to start to see some downgrades as we see this slowdown take hold. That happens every cycle. Sometimes you have forced sellers that have to get out of bonds that were downgraded from BBB into BB. We look at that as an opportunity – with a very long-term investment horizon for these investments.

How Are You Thinking About Fixed Income Portfolio Positioning in 2023?
I would call this a bond picker’s type of market. This is not a market where we’re going to add risk across the board and just raise the risk profile of the portfolios because everything looks cheap. There are some select opportunities out there. Flexibility is really important. So to have the flexibility to use areas like securitized assets, CLOs (collateralized loan obligations), or even some of the consumer or corporate asset-backed securities out there is advantageous. Looking at non-dollar and emerging markets debt, I think will be important, too.

We are really focused on yield advantage. The good thing about fixed income markets today is there’s yield. There’s cushion in fixed income portfolios to help protect against a downturn, spread widening, and higher rates. That’s something we haven’t had for the last couple of years.