Late Expansion Value in Corporate and Convertible Bonds

As we move into the second half of what has been a volatile year for capital markets, some recurring themes persist. As Brian Kennedy of Loomis, Sayles & Company's Full Discretion Team shared in the AssetTV Masterclass video above, selective opportunities begin to emerge in corporate debt during this Late Expansion phase of the credit cycle. Another theme is the Federal Reserve's ongoing efforts to make up ground with rate hikes. We probed further for Brian's insights on these and related topics below.

Have global growth concerns changed your team’s view about where we are in the credit cycle?
Our portfolio construction process begins with a top-down macro view of the marketplace, with credit cycle phases a key consideration. Currently, our base case is that we remain in the Late Expansion phase. We also expect inflation to persist.

Let’s dive right into your Inflation outlook.
Our base case is what we call sticky-flation, or sticky inflation. Even after we straighten out short-term issues like supply chain challenges and Covid, we still think some impactful longer-term trends could remain with us for quite a while. Issues like deglobalization, where economic regions want to secure their supply chains closer to home, will be more costly. Another longer-term, expensive theme that we’re seeing in the marketplace is the impact of ESG and decarbonization.

I would also point to some of the sustained demand for labor we’re witnessing. Given the strong employment numbers released in July, we can expect wages to continue rising along with a need for workers. As a result, we think longer-term inflation will likely be higher than what we experienced in the decade pre-Covid.

Do you expect continued Fed tightening to fight inflation?
Absolutely. We think the Fed is in full inflation fighting mode. Beyond the US, we expect to see central banks globally continue to raise rates in similar efforts. That’s really the number one priority for banks right now. They need to get it under control. The banks are regaining some credibility, given they’ve been far behind the curve recently. But they certainly still have some work to do. So we’re expecting significant rate hikes going into the end of the year.

Do you think we are headed into a recession?
While growth concerns are certainly an issue – and we think growth is trending lower – at this time, we’re not expecting a recession. In our view, there’s a probability recession could occur, but it’s not our base case at this point in time. Our base case is that we remain in expansion phase and move more towards the trend growth in the US that we’ve seen over the last couple of decades. Also, let’s not forget that China is providing enormous stimulus right now. China’s been in the downturn portion of the credit cycle for some time and is looking to emerge from that. Improved growth out of China would be a nice boost to the global economy.

That said, the markets are becoming very attractive given current growth concerns. As value-oriented investors, we’ve been selectively adding to risk assets as these markets are getting a bit more cheap.

What is your outlook for corporate bonds?
This is getting to be a pretty interesting market with high yield market yields currently between 8½ - 9%. Those are numbers we haven’t seen in quite a while, with high yield spreads starting to reflect slower growth and potentially slightly higher default rates. We expect high yield default rates to remain low for the next 12–18 months, which is below long-term averages. We’re starting to look at that sector for opportunities and adding selectively to some of our high conviction ideas.

We also see low-rated investment grade bonds – BBBs – with yields at close to 5% as a pretty attractive area.

Are there other areas where you are finding value?
We have expanded our look at high yield and have seen tremendous amounts of convertible bond issuance in the last couple of years. Opportunities are emerging in the tech space, along with some of the stay-at-home companies, where equity valuations have come down significantly. And there are lots of what we call “busted converts” out there right now, which are not as equity-sensitive but are trading at significantly lower dollar prices than where they were at first issuance.

I’d also point to European credit and add that as much as recession fears in the US are starting to percolate, they’re probably even more pronounced in the European markets. So we’re starting to look at select European credit, as well.

Clearly, there are a number of areas that make sense to start nibbling at right now. That said, we’re not likely to jump in with both feet immediately. But as the markets continue to show weakness and buying opportunities and value become more evident, we’ll apply our long-standing approach. As long-term investors, we’ll leverage our extensive research to buy into these downturns and find value to add to our portfolios – in addition to adding yield.

How are your portfolios positioned today?
Most of our portfolios have more yield than duration now, which can help to defend against rising rates, especially with solid security selection. So our selective purchasing helps offset either spread widening or higher rates. We’re taking risk down a bit and starting to redeploy the reserves we built early in the year, using them selectively where we see good value.