7 Fixed Income Market Perspectives from Loomis Sayles
When will the pace of Fed hikes slow down? Are there opportunities to tap amidst volatility? What risks are on the horizon? Investors have a lot of questions on their minds about the fixed income market after witnessing steep downturns in 2022. To help make sense of global fixed income markets today, Loomis, Sayles & Company’s Elaine Stokes, EVP, Co-Head & Portfolio Manager, Full Discretion Team, shares her views.
Does 2022 seem like an outlier? Or does it remind you of another down market?
Overall, it definitely feels like an outlier. The combination of a pandemic followed by a war - and really the underpinning of the whole financial system - feels very different than any time before. Also, the amount of pain experienced on both sides – equities and fixed income – is quite different. They are usually yin and yang.
We also have massive structural changes going on in the background: deglobalization, climate change, the great move to work from home, the new focus on cybersecurity, nationalism, and populism. It feels like there are so many structural changes going on at the same time. It doesn't feel cyclical at all, which makes it feel very unique. And, quite frankly, we've had a weaponization of commodities in 2022. So, that feels like something different that's going to reshape things going forward.
What’s the likely path of inflation from here?
Our view is that inflation is going to remain sticky and that the risks to inflation are to the upside. So why do I say that? First, because a lot of these changes are structural. There appears to be something structural going on in labor, housing, and energy. That will take some time to work out. We also have the zero-Covid policy issue in China which is going to unleash a lot of pent-up demand and could be inflationary when eased.
How might the Fed move to fight inflation going forward?
The Fed is going to do exactly what it's telling us. They raised rates in November another 75 basis points, and my guess is it will be another 50 bps, and then probably 25 bps. They're trying to trail off in how much they do with rates. They're also trying to give the market some time to react to the two things that hurt demand. Inflation in and of itself is going to hurt demand, and then rising interest rates are going to hurt demand. We're already seeing that in the housing market. I think the Fed would like to be able to take their foot off the gas and let some of what they've done work its way through the system, and see if that squelches demand a little bit. But they also want to have a few hikes left in their pocket in case they need to hike again if something does happen, like China retracting its zero-Covid policy.
Where do you see the credit cycle? Are we close to a recession?
If you were to look at a clock, we've probably moved from 4 o'clock to 5 o'clock, or maybe 5:30 – with 6 o'clock kind of hitting the downturn phase. So we think the probability of recession is higher. And we are getting closer to that downturn, as the Fed has told us as much. But there is some hope on the severity side. We still believe that consumers and governments are starting from a very strong place. There has been no need to overexpand during the last couple of years because we've been in a pandemic. We had easy money, very accommodative, and an almost generous Covid policy that has left both the consumer and businesses in a pretty good place.
How is this corporate health playing out in bond markets?
On the corporate side, it’s evidenced by a 2-to-1 in upgrades to downgrades. And we’re seeing one of the highest quality ratings we've ever seen for the high yield market. The expectations for defaults in this cycle are very low because of the early default cycle we went through in 2020 due to Covid. Defaults are expected to tick up a little bit, but defaults remain well below averages. So, that puts us in a place, at least in the parts of the traditional markets that we cover, where we believe that these companies are in pretty good shape and should be able to withstand the downturn of a recession.
Do you expect the lack of liquidity to persist? How does it affect where you’re looking for opportunity?
I absolutely think it’s going to persist. There are several reasons why. First, there’s a lack of issuance. There has really been no real need for issuance from a lot of corporate America because of the low-yield environment we were in. They’ve been dealing with easy money for several years. Also, the intermediaries have really been pulling back, closing down their risk budgets, and that is showing. It's also a structural issue. The sheer size of the market of tradable securities versus the intermediaries is just way out of balance.
Now, has illiquidity affected the opportunities we're seeing out there and how we're attacking the markets? Absolutely. To me, this volatility caused by this lack of liquidity is the opportunity. So we are focused on trying to figure out where it is on any given day. For example, when the UK pension funds are suddenly being forced to sell, well, where are they selling? We have definitely seen that pressure play out in emerging markets, so we started buying some traditional investment grade and high yield corporates. That gives us an opportunity to pick off some names that we think are attractive, and to build positions in those names.
What aspects of the Full Discretion team's approach have helped weather 2022's storm?
I think our duration management helped us a lot this year. We have been short for the majority of the year. The 10-year US Treasury yield has gone from 1.5% to 4%, so being short helped. We have also done really well with issue selection.
Also, in our Investment Grade Bond strategy, we moved to zero currency and zero equity a few years back. Both of those asset classes did poorly this year, so that probably helped us. Those changes also forced us to be a little bit more thoughtful and creative about where we wanted to be within the fixed markets. And the one area we have been using quite a bit more than we had in the past is securitized assets. We've really spent a lot of time working with our securitized team at Loomis Sayles to build those holdings and get really comfortable with issue selection within securitized. This has worked well for us.
Does 2022 seem like an outlier? Or does it remind you of another down market?
Overall, it definitely feels like an outlier. The combination of a pandemic followed by a war - and really the underpinning of the whole financial system - feels very different than any time before. Also, the amount of pain experienced on both sides – equities and fixed income – is quite different. They are usually yin and yang.
We also have massive structural changes going on in the background: deglobalization, climate change, the great move to work from home, the new focus on cybersecurity, nationalism, and populism. It feels like there are so many structural changes going on at the same time. It doesn't feel cyclical at all, which makes it feel very unique. And, quite frankly, we've had a weaponization of commodities in 2022. So, that feels like something different that's going to reshape things going forward.
What’s the likely path of inflation from here?
Our view is that inflation is going to remain sticky and that the risks to inflation are to the upside. So why do I say that? First, because a lot of these changes are structural. There appears to be something structural going on in labor, housing, and energy. That will take some time to work out. We also have the zero-Covid policy issue in China which is going to unleash a lot of pent-up demand and could be inflationary when eased.
How might the Fed move to fight inflation going forward?
The Fed is going to do exactly what it's telling us. They raised rates in November another 75 basis points, and my guess is it will be another 50 bps, and then probably 25 bps. They're trying to trail off in how much they do with rates. They're also trying to give the market some time to react to the two things that hurt demand. Inflation in and of itself is going to hurt demand, and then rising interest rates are going to hurt demand. We're already seeing that in the housing market. I think the Fed would like to be able to take their foot off the gas and let some of what they've done work its way through the system, and see if that squelches demand a little bit. But they also want to have a few hikes left in their pocket in case they need to hike again if something does happen, like China retracting its zero-Covid policy.
Where do you see the credit cycle? Are we close to a recession?
If you were to look at a clock, we've probably moved from 4 o'clock to 5 o'clock, or maybe 5:30 – with 6 o'clock kind of hitting the downturn phase. So we think the probability of recession is higher. And we are getting closer to that downturn, as the Fed has told us as much. But there is some hope on the severity side. We still believe that consumers and governments are starting from a very strong place. There has been no need to overexpand during the last couple of years because we've been in a pandemic. We had easy money, very accommodative, and an almost generous Covid policy that has left both the consumer and businesses in a pretty good place.
How is this corporate health playing out in bond markets?
On the corporate side, it’s evidenced by a 2-to-1 in upgrades to downgrades. And we’re seeing one of the highest quality ratings we've ever seen for the high yield market. The expectations for defaults in this cycle are very low because of the early default cycle we went through in 2020 due to Covid. Defaults are expected to tick up a little bit, but defaults remain well below averages. So, that puts us in a place, at least in the parts of the traditional markets that we cover, where we believe that these companies are in pretty good shape and should be able to withstand the downturn of a recession.
Do you expect the lack of liquidity to persist? How does it affect where you’re looking for opportunity?
I absolutely think it’s going to persist. There are several reasons why. First, there’s a lack of issuance. There has really been no real need for issuance from a lot of corporate America because of the low-yield environment we were in. They’ve been dealing with easy money for several years. Also, the intermediaries have really been pulling back, closing down their risk budgets, and that is showing. It's also a structural issue. The sheer size of the market of tradable securities versus the intermediaries is just way out of balance.
Now, has illiquidity affected the opportunities we're seeing out there and how we're attacking the markets? Absolutely. To me, this volatility caused by this lack of liquidity is the opportunity. So we are focused on trying to figure out where it is on any given day. For example, when the UK pension funds are suddenly being forced to sell, well, where are they selling? We have definitely seen that pressure play out in emerging markets, so we started buying some traditional investment grade and high yield corporates. That gives us an opportunity to pick off some names that we think are attractive, and to build positions in those names.
What aspects of the Full Discretion team's approach have helped weather 2022's storm?
I think our duration management helped us a lot this year. We have been short for the majority of the year. The 10-year US Treasury yield has gone from 1.5% to 4%, so being short helped. We have also done really well with issue selection.
Also, in our Investment Grade Bond strategy, we moved to zero currency and zero equity a few years back. Both of those asset classes did poorly this year, so that probably helped us. Those changes also forced us to be a little bit more thoughtful and creative about where we wanted to be within the fixed markets. And the one area we have been using quite a bit more than we had in the past is securitized assets. We've really spent a lot of time working with our securitized team at Loomis Sayles to build those holdings and get really comfortable with issue selection within securitized. This has worked well for us.
Flexibility to Pursue Value Opportunities Across Global Markets
While fixed income markets face shifting dynamics and challenges, volatility often creates value opportunities. Loomis Sayles’ flexible, multisector strategies actively pursue undervalued bonds with favorable current yields across global markets.
Securitized products are securities that are constructed from pools of assets that make up a new security, which is split up and sold to investors. Securitized products are valued based on the cash flows of the underlying assets.
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.
High yield fixed income securities may be subject to greater risks (including the risk of default) than other fixed income
securities.
The yield spread is the difference in the expected rate of return between two investments.
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.
Duration risk measures a bond's price sensitivity to interest rate changes. Bond funds and individual bonds with a longer duration (a measure of the expected life of a security) tend to be more sensitive to changes in interest rates, usually making them more volatile than securities with shorter durations.
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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. Currency exchange rates between the US dollar and foreign currencies may cause the value of the Fund's investments to decline.
Below investment grade (high yield) fixed income securities may be subject to greater risks (including the risk of default) than other fixed income securities.
Mortgage-related and asset-backed securities 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.
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