Top 5 fixed income ideas for 2024

Amid aggressive central bank tightening campaigns, a mini-banking crisis, escalating geopolitical tensions, and persistent inflation, fixed income markets generally delivered strong returns in 2023, benefiting from high carry and spread tightening. With central banks set to pivot to accommodative policy, and elevated yields still prevailing, we think fixed income markets offer many compelling opportunities. We are excited to share our top five fixed income ideas for 2024.

1. Unconstrained fixed income: We believe total return fixed income strategies that are less constrained by benchmarks are well positioned to navigate the late stage of the economic/credit cycle that we appear to be entering. In a late-cycle environment of expected declining yields and increased volatility, dynamic rotation across a broad opportunity set of fixed income sectors offers the potential to generate higher risk-adjusted returns with lower volatility than do equities. As central banks chart different policy paths, this should lead to dispersions in economic growth and inflation, creating market dislocations. We also think it is important for investors to stay flexible and nimble with their portfolio allocations in an uncertain market landscape. That includes having sizable allocations to liquidity and developed market government bonds to be able to capitalize on market opportunities as they arise.
2. Core bond plus: While fixed income markets rallied sharply to close out 2023, we believe there is scope for yields to remain supported by expected weaker growth and as central banks pivot to more accommodative monetary policies. Core bond plus can offer protection in a downside scenario in which the economy slows more than forecast. Still-elevated government bond yields mean that these strategies offer some of the highest carry and income levels since before the global financial crisis. These approaches tend to focus on alpha generation through security selection primarily across investment-grade credit and securitized issuers. And duration should be able to serve as a counterbalance to credit risk if there is a sudden deterioration in credit fundamentals. We expect the typical negative equity/bond correlation to be reasserted in weaker inflationary environments.
3. Higher-quality securitized credit: Another sector in which one does not have to dip down in the quality spectrum to achieve income and carry lies in the high-quality securitized space. Spreads are generally wider for the same rating in corporate bonds but with differentiated risk. Many of these deals are embedded with strong subordination (lower tranches absorb the first losses), helping to insulate them from deteriorating fundamentals. Areas rich in idiosyncratic opportunities for active managers include commercial real estate (CRE) and consumer subprime debt. While CRE has its challenges, they have been well telegraphed. Consumers are generally returning to a more normal state following a massive fiscal stimulus. Delinquencies are expected to increase but asset-backed securities benefit from strong structural features including shorter duration and natural delevering from principal amortization.
4. CLO equity: Despite elevated recession risk heading into 2023, CLO equity was included among our best credit ideas on the thesis of wide spreads and the ability to lock in term financing. That view proved prescient with CLO equities delivering returns of 14.51%, based on the Citi Post-Crisis CLO Equity Index. If the economy does indeed experience a “soft landing,” CLO equity should be a strong performer. Issuance of CLOs fell for a third consecutive year and is expected to further decline as deals exit reinvestment this year, providing a favorable technical tailwind. And fundamentally, Federal Reserve rate cuts will help reduce the interest costs of individual bank loan issuers, in which CLOs invest. We still expect to see periods of spread volatility, which would give CLO managers the ability to reinvest at more attractive levels. CLO liabilities are also getting cheaper, enabling equity investors to lock in historically tight term financing. Historically, this has been an attractive time to create deals since investors can lock in cheap financing and capitalize on rate volatility.
5. Convertible bonds: Following the sharp tightening of credit spreads at the end of 2023, convertible bonds are one of the few fixed income sectors that still offer positive convexity. To some extent, converts offer the “best of both worlds.” Exposure to growth-oriented sectors provides the opportunity to outperform other fixed income spread sectors when equity markets are rallying; meanwhile, their bond floors give convertibles greater downside protection when equities are out of favor. The converts market offers investors exposure to companies that don’t otherwise have corporate debt outstanding. Many issuers that are earlier in their life cycle and growth trajectory are often capital constrained and see investing internally in growth as a more attractive use of capital than paying cash interest.
   
   From a market segment perspective, we tend to find the balanced part of the market the most favorable over the long term. Moreover, as our Equity Strategist Andy Heiskell has noted, there is a strong chance that we could see small-cap equities rally in the coming months. Converts would be the fixed income market’s expression of that view. However, we currently see the busted segment as having greater-than-usual value, offering comparable yields to high yield but with higher credit quality. Lastly, we are finding some of the best opportunities in companies that are focused on cybersecurity, artificial intelligence, and health care innovation themes.