5 Viewpoints for Fixed Income Investing in Late Credit Cycle

At this late phase in the market cycle, now is not the time to be reaching way down in credit quality, says Elaine Stokes, Co-Head of Loomis, Sayles & Company’s Full Discretion Team. In this talk with Natixis’ Investment Strategist Erica Casale in April 2023, she shares views on the Fed’s interest rate path, the growing importance of global commodity players, and the select opportunities her team is watching at this late stage in the credit cycle.

1. How are you viewing the banking sector after recent volatility?

Elaine Stokes: Outside of the US and in the larger US banks, regulation is strong, and we see a secure banking system. The bank failures we saw in April were more isolated. What really caused these bank issues to happen was that money is moving away from riskier investing. It’s moving away from investing in crypto, startups, and venture capital – and moving back into more traditional markets. This could be viewed as a proof point for us that the central bank policy is working.

Also, we now see that lending is shifting away from riskier bets to safer bets. And I do think we will see continued tightening of lending standards as we tip into an economic slowdown or downturn. When there is any type of hiccup, liquidity just disappears. And when you're talking about a hiccup in the short end of the US Treasury curve, which everything else is priced off of, it can really be something that's very destabilizing. But once again, we got security that governments are going to step in. They stepped in quickly to help take care of the failed banks and to right the markets. So one takeaway for me is that central banks are still going to remain very involved in the markets for the foreseeable future.

2. Do you expect the Federal Reserve (Fed) to pivot its interest rate strategy?

The market is saying potentially we get one more quarter-point Fed rate hike, then possibly a couple of rate cuts by the end of the year. By January 2024, there could be three cuts. But what is my takeaway? I believe the range of outcomes for what the Fed is going to do is much tighter: a 25 basis points (bps) hike, then maybe a pause, and potentially 25 or 50 bps down through the course of the year. If that is all we see for the rest of 2023, that is not destabilizing in my view. That is something we as fixed income managers can work around. What we now must look at is portfolio risks shifting from interest rate risk to credit risk. This is a mindset I feel much more comfortable with as an active manager.

3. What’s happening in the global marketplace?

Well, the biggest thing right now in the global marketplace is that we all went into the last economic downturn, which was driven by Covid in early 2020, together. But countries have all come out of it at different paces and spent different amounts of money at different times. We are witnessing the unlinking of the global credit cycle.

The other thing we believe is super important as we go through this deglobalization, which is almost a zoning-off of world economies into like-minded groupings, is that commodity players are going to be extremely important. There are some very large countries with commodities and some small countries with commodities. So I think it's going to be important for us to really understand the levers that those countries can pull.

4. Is recession looming? Should fixed income investors be concerned?

We still believe we're in the late expansion phase of this market cycle. We're starting to see the cracks. The Fed’s policy actions of last year are working and we are seeing a slightly slower economy. But there’s still surprisingly mixed data. That is what keeps us in the camp that the Fed might only raise in May and then pause. However, we don't feel like there are going to be a lot of quick rate cuts in the near term. We still see employment just a little too strong. We still see inflation also just a little too strong because there really are a lot of tailwinds to inflation from a more secular story like the deglobalization, decarbonization, and demographics. A lot of those things are still a push to keep inflation up.

The other thing that we think is interesting about the way this cycle may play out is that consumers are still pretty strong – mainly because they are employed. The consumer is still spending and the services sector is doing fine. The cracks that we're seeing are really on the manufacturing side of the economy.

5. Among the six pillars you look at for security selection, which ones are interesting now?

If you asked me in early March 2023, it would be “Stressed/Destressed” (see Figure 1). We were focused on what's going on in the banking system and what are the value opportunities. We were rolling up our sleeves and trying to decide what to buy within banking and finance. Also, when you're this late in the cycle, you're going to continue to have those types of opportunities.

“Avoid Losers” is another important pillar when you're going into a downturn. So this is not when you reach down in credit quality to triple Cs. The same reason why investors are kind of steering clear of startups, venture capital, and crypto is why we are being really careful about what triple C bonds we are looking at. We think it makes sense to stay away from those lower-rated credits that don't have a solid story.

Figure 1: Six Pillars of Security Selection

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.

Also, we have been fortunate to still be riding that “Upgrade Candidates” wave – which is unusual given how late we are in the credit cycle. Finally, “New Issues” is an area that has been sparse. But every once in a while, a new issue comes in that excites us. If it’s one of those issues that isn’t so easy to get done in the marketplace, we are willing to do the extra work and step in.

For more in-depth fixed income insight from Loomis Sayles Full Discretion Fund Managers listen to their quarterly podcasts here.