Structuring core fixed income: A constructive view on market and macro conditions

Head of Multi-Asset Strategy Adam Berger and Fixed Income Portfolio Manager Connor Fitzgerald discuss the shifting interest-rate regime, the fundamental picture in investment-grade credit and high yield, and the underappreciated benefit of strong fiscal support.

Adam: The interest-rate regime has shifted dramatically the past couple of years. How has that altered the opportunity in US core fixed income?

Connor: With yields now much higher than over the previous 15 years, I think fixed income looks attractive on an absolute basis and relative to history. When yields rise, investors get more income from the asset class, but there’s another point that often gets overlooked: the fact that durations are lower. So, along with more income, there may also be less price volatility. That’s very different from what we saw after the pandemic, when yields were much lower and durations were much higher — meaning that the prospect of principal losses was greater if rates rose.

The top chart in Figure 1 illustrates the point with a simple example. It shows the total return impact of a 1% move up in yields and a 1% move down in yields on a current vintage 30-year corporate bond and a pandemic-vintage corporate bond. Looking over a one-year horizon, we see the current vintage bond (left side) has a more stable total return profile, which may be attractive to investors allocating to fixed income today.

Figure 1

Adam: The market is very focused on the Fed’s next interest-rate move. What’s your view on the current macro outlook?

Connor: A lot of market participants are trying to time their investment decisions around the start of Fed rate cuts, but that is difficult and, in my view, not necessary. I think this is a good time to consider allocating to fixed income, but maybe not going all in if you think there’s a risk of rates moving higher. From a macro standpoint, I tend to focus on how the economy is impacting the cash flows of different sectors and companies, rather than trying to predict how the macro landscape will evolve. That said, I have a pretty optimistic view on the US economy right now. The consumer balance sheet is quite healthy and has very low sensitivity to interest rates. That suggests that the prospect of a consumer-led slowdown is low, which reduces the potential for a downside outcome on investment-grade credit spreads.

Adam: How would you assess the investment-grade and high-yield markets in terms of fundamentals? 

Connor: Whether it’s investment-grade or high-yield credit, my view is generally constructive. During the pandemic, we saw a lot of companies take out debt and put cash on their balance sheets, almost like an insurance policy. Then when the economy recovered quicker than expected, many chose to pay down that debt in 2021. Before there was a chance for late-cycle animal spirits to get going with a releveraging cycle in 2022, the Fed started tightening and companies moved to protect their balance sheets further, whether by cutting spending or dividends. So, balance sheets continued to improve in 2022 and 2023, leaving us with a strong fundamental picture in credit. 

Technicals are also favorable — I don’t see a lot of companies excited to add debt at these yield levels just as there’s a lot of money coming into the market. In terms of valuations, spreads are tight, but if you look under the hood, there’s still plenty of dispersion and some potentially good opportunities. For example, I think many areas of the financial sector are attractive, and the sector is cheap versus the market on a historical basis. 

Generally speaking, I’m less excited about high-quality 30-year credit. There’s been a significant supply squeeze in that part of the market, so it is trading at close to the tightest levels in history.

Finally, let me offer a few thoughts on high yield in particular: Spreads are tight, but I still see attractive opportunities. For example, I think there’s room for some sectors and names in high yield to compress tighter — areas where the market has been concerned about refinancing and debt rollover risk. The capital markets are wide open right now, and while that might be a contrarian signal, it’s a very bullish proposition for some companies that need to refinance.

Adam: You’re a student of the market and often share views beyond credit, including on equities and other asset classes. What’s your view on the broad market narrative that’s currently driving performance? Are there any areas you’re concerned about? 

Connor: As I wrote recently, I think the markets have for the past couple of years been over-indexed to the Fed’s interest-rate decisions and under-indexed to the impact of US fiscal stimulus. It’s hard to imagine having a recession in the US when we’re at full employment, the economy seems to be doing fine, and the federal government has the market’s back in terms of stimulus. I don’t see that fiscal commitment changing this year — certainly not as we head into the election. Longer term, I will be watching for any indication the government has gotten a little religion in terms of its spending, because that would slow the economy and result in less Treasury supply and a big move lower in yields. But I think that’s more of a two- to four-year event than a one- to two-year event.

The other macro risk I’d highlight relates to the Fed and whether it’s done enough to stem the tide of inflation. Despite a major hiking cycle, there hasn’t been much of an impact in terms of asset prices, whether that’s home or stock prices. That’s left a lot of net wealth in the system, and I’m a big believer in the wealth effect — people spend more when they feel wealthier. From an inflation standpoint, that could put the Fed in a tough spot. 

While these macro risks bear watching, there aren’t any particular sectors where I could see them reaching a level that could cause a systemic issue in credit.