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Investors hoping to see markets in 2024 shrug off the volatility and uncertainty that defined 2023 have been left disappointed. Disruption and change continue to challenge investment decisions amid ongoing geopolitical fragmentation, relentless swings in markets, and increasing divergence in monetary policy, economies, and supply chains. However, we see clear opportunities supporting investing in fixed income. And credit appears to offer a nuanced component to navigate today’s macro landscape.
A key difference from last year is that investors know they cannot sit on the sidelines for much longer now that interest rates appear to have peaked. Inflation is likely to remain high, due to both supply and demand factors, and the US Federal Reserve (Fed) might cut rates by less than markets expect.
Yet company revenues and levels of leverage could mean that default rates peak lower than expected, which is typically associated with a tightening in credit spreads, which would spell good news for corporate bond returns. As a result, investors may want to consider moving incrementally into longer-maturity fixed income sooner rather than later to lock in attractive yields now, before the Fed begins cutting rates and markets price that in.
The fixed income team puts a lot of effort into trying to understand how the Fed’s reaction function might evolve. Through experience, we have found that it is more important to invest based on the economic reality that the Fed faces, rather than focusing solely on what it’s trying to communicate and the subsequent market reaction. For example, over the past few months, our skepticism that the Fed would engage in aggressive rate cuts led us to hold more cash than we would on average, meaning less duration.
On balance, we expect longer-term rates to be a bit more stable than short-term rates. As a result, although last year saw investors look to stay in cash and time the markets, changes in rates are unlikely to be the biggest driver of returns this year. We are more focused on relative-value credit decisions, forecasting credit returns in excess of whatever rates do.
With starting yield levels offering a much more appealing cushion for fixed income portfolios than they did a few years ago, credit is performing better now than many people expected. Coupled with dispersion across markets, this backdrop translates into pockets of value in specific sectors for investors — including bank loans, emerging markets (EM) corporate debt, select European high-yield names, financials, structured finance and certain African credits.
We believe that the bond market's reaction to eventual rate cuts will depend on why the Fed is cutting. If the Fed cuts rates because growth has weakened more than expected, investors will likely want to buy high-quality long bonds. On the flipside, if the Fed cuts because inflation has fallen but growth remains relatively strong, we will see a soft landing and investors will likely opt for riskier bonds such as low-quality, including EM, debt.
As investors seek value in today's investment landscape, we think that a top-down, credit barbell strategy can lead to a more optimal risk/reward portfolio. More specifically, a common school of thought among investors is to buy investment-grade (IG) credit to reduce risk and buy high yield to add it. Instead, when IG is expensive (as it seems to be today), a better strategy to reduce risk might be to balance high-yield exposure with high-quality securities like Treasuries and asset-backed securities.
With this in mind, an often undervalued and underappreciated part of the market is the EM corporate sector. The current risks of tight policy are more relevant to the US than EMs, which look better value amid inflation being under control. In particular, many EM corporates derive their revenues from developed markets, so can be more stable than their underlying countries, and investors are still receiving an attractive risk premium, especially in some BB and B names.
Ultimately, we think the new market environment calls for a more nuanced and active approach to credit in order to find the most promising opportunities. When looking for those opportunities across different sectors of the global fixed income universe, we consider various factors. How much active credit risk should we take? Which sectors should we use to take our desired amount of credit risk? And are we getting suitably compensated? Incorporating deep research and taking an active approach is, in our view, the most effective way for investors to take advantage of today’s more volatile market environment.
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