- Fixed Income Strategist
Portugal, Intermediary
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In a whitepaper published earlier this year, two of my colleagues and I opined that fixed income — particularly higher-quality assets — looked poised for a strong 2023 recovery from last year’s dismal market returns, which depressed valuations to very attractive levels in many instances. As we now approach midyear, that healing process from the debacle of 2022 has begun in earnest: Despite some bouts of macro turmoil along the way, year to date, most fixed income sectors have posted positive excess total returns relative to duration-equivalent government bonds.
I view the balance of 2023 as continuing to present investable opportunities for discerning fixed income allocators. To be successful, however, I believe it’s important to choose your entry points carefully and to be mindful of the risks that the current investment landscape poses.
My three big takeaways for investors
In an environment of persistent inflation, higher policy interest rates, and other macro headwinds, I would highlight the following key takeaways for fixed income investors:
Favor high-quality fixed income sectors. Globally, interest rates remain historically high in the wake of the rate-hiking campaigns pursued by the US Federal Reserve (Fed) and other central banks in their effort to rein in stubborn inflation. Recent incoming data shows that the global economy is decelerating, though not as fast as one might expect amid today’s meaningfully tighter monetary policy, highlighting how effective fiscal policy was in combating the sharp economic downturn triggered by the initial COVID outbreaks in 2020.
However, I am bracing for the lagged effects of tighter monetary policy, which are typically long and variable, to further slow the global economy in the period ahead. A recession is still possible later this year, especially in the US. Against said backdrop, I suggest that many investors lean into high-quality fixed income sectors that may be more resilient in the face of economic challenges and credit-rating downgrades.
Market volatility is likely here to stay. While I don’t anticipate the same degree of heightened volatility as last year (when capital markets were caught off guard by rapid rate-hiking cycles), I think there is likely to be ongoing volatility in most markets, including fixed income. This volatility could arise from multiple sources:
- Inflation: While gradually abating in the US, global inflation has proven to have greater staying power and to be far more pernicious than most market observers would have thought just a couple of years ago. However, I believe the worst of it may now be behind us and, accordingly, that we may finally have reached (or at least neared) the “event horizon” of the longer-term interest-rate market (Figure 1).
Figure 1
- Interest rates: Higher rates are arguably now compensating many investors for today’s volatility. While global central banks are moving at different paces, broadly speaking, I do not expect an immediate return to a low-rate world. Rates may trend lower over time but, short of a severe recession, are unlikely to decline precipitously. Under this scenario, fixed income may provide positive carry and diversification benefits.
- The banking sector: I believe the recent high-profile strains in the banking sector, notably among many regional US banks, have underscored some fragility in global financial “plumbing” as monetary policy worldwide has become decidedly less accommodating. The financial system is clearly starting to reveal cracks in its proverbial armor.
- Geopolitical risks: Take your pick. The protracted Russia/Ukraine conflict, global trade dynamics with China, and the unpredictable North Korean regime are just a few of the geopolitical risks that could periodically roil capital markets in the months ahead. In the US, political brinkmanship around raising the debt ceiling is a growing concern these days.
Credit looks priced fairly but pick your spots. I continue to like senior parts of the corporate capital structure and high-quality liquid sectors such as agency mortgage-backed securities, as well as select portions of the investment-grade credit universe. Core and core-plus bond strategies may offer carry and risk diversification into a flagging economy, while some global sovereign debt and macro-oriented strategies may be beneficiaries of market volatility. Moreover, long/short credit portfolios may be one way of capturing structural inefficiencies and emerging dislocations in the credit markets. Another avenue, for investors who can use leverage and stomach potential volatility, might be to lock in term funding to purchase credit via a collateralized loan obligation vehicle.
Stay flexible, nimble, and opportunistic
To recap, I am confident that additional fixed income investment opportunities should crop up in the coming months and quarters. From an allocator’s perspective, I believe being flexible, nimble, and opportunistic will be critical to capitalizing where appropriate and maximizing upside potential in a risk-aware manner.
