Despite impressive returns for bonds across the spectrum in the first half of 2019, trade war tensions, signs of slowing global growth and a dreaded inverted yield curve1 have many income-focused investors asking “What’s next?”

For Chief Market Strategist at Natixis Investment Managers, David Lafferty, recent economic indicators combined with geopolitical turmoil should serve as a warning for investors to reevaluate portfolio allocations and take on more cautious positioning. “Caution, however, does not mean dumping risk assets, especially as we’re very skeptical of market timing. It should mean finding lower-volatility, lower-risk ways of staying in the market,” said Lafferty.

While he believes returns should remain in positive territory for 2019, Lafferty does see more volatility on the horizon. “For now, our base case is not a recession in the next 6 to 12 months, but we see the upside being more limited. We don’t see the Fed’s accommodative pivot as a game changer nor do we expect much real progress in US/China relations.“

Also, Lafferty does not think we are on the edge of a corporate credit bubble as some market prognosticators have suggested. “While corporate debt outstanding is up significantly since the Great Financial Crisis, the coupon/yield associated with the debt has fallen significantly. By our back-of-the-envelope calculations, these two effects nearly cancel out, leaving the debt service burden of US and European investment grade companies up only slightly,” said Lafferty. At today’s levels of indebtedness, he believes, credit concerns are more about market access and the ability to roll over maturities than about debt service itself.

Pursue Income and Manage Risk
Utilizing skilled active fixed income managers with flexible mandates is one way to take the guesswork out of when to make shifts in quality, durations and sectors. Risk management is another important factor active managers provide that shouldn’t be overlooked in today’s uncertain investment landscape.

In fact, as the popularity of fixed income index funds has ballooned in recent years, it may be wise for investors to gut check their risk assumptions. A stunning 64% of investors surveyed for the Natixis Investment Managers 2019 Global Survey of Individual Investors2 believe index funds will help minimize losses, while 57% believe they provide access to the best opportunities in the market. Clearly, investors need to better understand the fundamental differences between active and passive investing.

Be Very Flexible
Flexible frameworks among Loomis, Sayles & Company’s fixed income strategies, including Core Plus, Multisector Full Discretion, Strategic Alpha and Senior Floating Rate, enable portfolio management teams to pursue attractive value and yield opportunities while avoiding potential danger zones. In fact, well before the China-US tariff escalations, Fed rate cut, and mid-summer market flare-up, these teams were already implementing defensive measures in portfolios. Elaine Stokes, co-head of Loomis Sayles’ Multisector Full Discretion Team, believes their portfolios are well-positioned with an appropriate balance of risk, yield, liquidity and diversification to drive returns in the current environment. “Our defensive and reserve positions give us flexibility to adapt to changing markets and to identify opportunities as they arise,” said Stokes.

Keep Reserves at the Ready
Should markets experience a sharp pullback, the Multisector Team has been maintaining a level of reserves for future opportunities. Also, as US corporate bond market valuations shifted higher in the first half, they took some gains and became increasingly patient and selective. Moving up in quality was another prudent move.

“Our credit strategy remains focused on higher-quality issues given the late expansion phase of the credit cycle,” said Stokes. ”We are positive on the energy sector based on improved balance sheets and a favorable outlook for the price of oil. We are also maintaining exposure to the banking/financial sector as the overall credit quality remains positive, supported by tightened capital requirements.”

Overall, economic activity has not progressed as positively as anticipated this year. With global and US manufacturing coming under pressure, trade war concerns increasing, and tame inflation, the team believes the Fed could cut interest rates further. They don’t anticipate a US recession over the next 12 months given solid employment conditions and outlook for corporate profits. No significant uptick in corporate bond defaults is expected either.

Spend More Quality Time
Loomis Sayles Core Plus Bond Team co-managers Peter Palfrey and Rick Raczkowski have become more cautious in security and allocation decisions as well. In fact, their credit quality is the highest it has been since 2007. Running their nominal duration a little longer than the Bloomberg Barclays Aggregate (a high-quality government-oriented index) has been advantageous thus far in 2019, too.

“With AAA rated and government issues now over 70% of our holdings, we believe we are well-positioned for this current volatile environment, and have a significant liquidity position to reposition back into risk markets should opportunities arise,” said Palfrey.

Loomis Sayles' Core Plus strategy looks to add return in stable to improving risk markets and preserve principal during adverse markets using tactical portfolio allocations. During periods that call for more defensive positioning, the team generally adopts a higher-quality posture. This nimble approach has led to attractive long-term results through a range of economic and market environments.

One area where they are finding yield advantage, along with quality and liquidity, is in agency mortgage-backed securities (MBS). Secured, better-quality bank loans and Treasury Inflation Protected Securities (TIPS) are also interesting. “In light of what we consider an overbought nominal Treasury market, we expect TIPS to provide an attractive alternative to longer dated US Treasurys, especially as the Fed refocuses on generating and sustaining a more robust inflation outlook for the US economy,” said Palfrey.

Palfrey notes that corporate industry profiles appear consistent with late expansion – with slowing margin growth, increased mergers & acquisitions and rising leverage. Corporate credit remains in demand due to investors’ need for yield and positive fundamentals. “Overall, we favor corporate credit over risk-free assets as we move further into late expansion. We believe primary risks include uncertainties surrounding the pace of global growth, US trade policy, global central bank policy accommodation and the potential for further escalation of Middle East tensions.”

Diversify with Non-Traditional
With a wide opportunity set to draw from, Loomis Sayles’ absolute return-oriented Strategic Alpha approach looks to pursue positive returns in various market climates, dampen volatility, and act as a portfolio diversifier.

“Strategic Alpha is really an all-weather strategy designed to provide attractive risk-adjusted returns throughout market cycles while focusing on drawdown management and low correlations to major fixed income markets,” said Matt Eagan, co-manager of the Strategic Alpha strategy and co-head of the Multisector Full Discretion Team.

Given the risks of an aging credit cycle, Eagan says principal preservation will continue to be the emphasis in 2019. Active management of systematic risk (credit, currency and interest rate) is more critical than ever. To that end, Strategic Alpha’s duration is still quite defensive and higher-quality credits are favored. The team relies heavily on Loomis Sayles’ global research platform to identify sources of alpha or excess return and avoid risk.

One major market concern Eagan highlights is the wave of negative-yielding debt in the world and the amount of unintended risk investors may be taking on. “The riptide of negative-yielding debt has grown to about $16.7 trillion. That’s an astounding 45% of global investment grade debt outside the US trading at a negative yield,” said Eagan. Unfortunately, this bigger universe of negative yielders has investors taking more and more risk to find return.

“Consider that 10-year government bonds in Italy, which doesn’t possess rock-solid credit, yield less than 10-year US Treasurys. There are even European junk bonds with negative yields,” said Eagan. Compared to the rest of the world, the US is still a high yielder – and a relatively stable outpost. As a result, investors flocked to US Treasurys during August’s market turbulence.

Achieve Seniority Status
Adding exposure to the bank loans sector is another portfolio diversifier idea. Cheryl Stober, product manager on Loomis Sayles’ Senior Floating Rate Team, believes the value of seniority and security of bank loans is worth considering in the latter stages of credit cycles when rates may not rise or even may fall to some extent, and markets tend to get nervous.

“Some investors take a narrow view of bank loans and only see them as a tactical play that can benefit from rising interest rates. They tend to overlook two potential additional benefits – reduced volatility and enhanced yield potential,” said Stober.

As a rule, senior, secured loans sit at the top of the corporate capital structure and are secured by a company’s assets. “This means that loan owners get repaid first if a company enters bankruptcy,” said Stober. Subordinated high yield corporate bonds are next in line, with equity at the bottom. Overall, the Senior Floating Rate Team has a moderately constructive outlook on US corporate fundamentals. Despite the late cycle environment, the vast majority of companies they follow continue to have slowly growing earnings. And in a low-yield world they may offer yield pickup potential.
1 A curve that shows the relationship among bond yields across the maturity spectrum.

2 Natixis Investment Managers Global Survey of Individual Investors conducted by CoreData Research, February–March 2019. Survey included 9,100 investors; 25 countries.

Past performance is no guarantee of future results.

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.

The views and opinions expressed represent the subjective views of the contributors as of August 26, 2019. They are subject to change at any time based on market and other conditions. There can be no assurance that developments will transpire as forecasted. This material is provided for informational purposes only and should not be construed as investment advice.

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