Weekly Investment Commentary: Bullish on bonds
Bottom line up top:
- During the nearly two turbulent years from the Federal Reserve’s initial rate hike in March 2022 through the end of October 2023, taxable fixed income markets were particularly hard-hit. The seismic shift in monetary policy persisted longer than initially anticipated, as inflation proved to be anything but “transitory.” The Fed and other major central banks maintained their laser focus on bringing down inflation through rate hikes (Figure 1), aware that their aggressive tightening risked dragging economies into recession. Many investors spooked by this environment sold their bond positions and piled their money into cash and cash equivalents.
The outlook for fixed income from here looks far better. While inflation remains above central bank targets, it has moderated significantly. And a recession has so far been kept at bay. In fact, slowing but still-resilient economic growth has fueled market optimism that a “soft landing,” not a contraction, could be the ultimate outcome. Against this backdrop, in December the Fed signaled peak rates and adopted a dovish posture, projecting 75 basis points (bps) of rate cuts in 2024. Friday’s release of December’s Personal Consumption Expenditure (PCE) Index data supported the Fed’s stance, with both headline and core PCE (which excludes volatile food and energy components and is the Fed’s preferred inflation barometer) meeting expectations.
In pledging to stay data-dependent, the Fed will continue to proceed with caution, while awaiting further evidence that inflation has fallen far enough to justify lowering policy rates. Meanwhile, the European Central Bank and Bank of England have also put their rate hikes on “pause,” and to date have shown little inclination to telegraph sooner-rather-than-later rate cuts. The Bank of Japan, whose longtime yield-curve control policy had made it a dovish outlier among major central banks, is preparing to overhaul its approach, which would allow yields on Japanese government bonds to increase beyond their previously more-restrictive bands.
Given this caution across central banks — and contrary to what financial markets are currently pricing in — we believe the odds of Fed rate cuts occurring in the first quarter of 2024 remain low, and that the much-anticipated policy pivot won’t begin until midyear. Still, with inflation falling and monetary policy expectations recalibrating, we encourage investors to assess their taxable fixed income portfolio allocations and to take advantage of opportunities we see across the asset class.
“This cycle of rate hikes may be over, but we don’t anticipate seeing cuts until closer to midyear.”
We believe the recent increase in bond yields has created ample opportunity for investors to benefit from what should be several rate cuts this year (beginning later than markets expect). Our outlook calls for the 10-year U.S. Treasury yield to fall from current levels to finish 2024 around 3.50%. Accordingly, we think extending duration in fixed income portfolios could be wise. But with a slowing U.S. economy and cracks appearing in consumer resilience, we also think credit sectors need to be approached with nimbleness and flexibility.
- In some investment grade sectors, yields are now north of 5%. This higher-yield environment is driving greater dispersion and creating more opportunities to capture attractive returns. Investment grade corporate bonds, for instance, offer a longer duration profile, and their higher relative quality could provide a cushion if the economy weakens more than we expect.
- We also like some nontraditional sources of income such as higher quality asset-backed securities (ABS) and preferred securities. Consumer and commercial credit performance has stabilized, which is a positive for ABS. But should the economy slow, it would likely mean lower quality credit cards and auto loans would be the first to experience delinquencies and defaults. As for preferred securities, banks are facing increased regulation while continuing to pass the Fed’s rigorous stress tests, which bodes well for investors.
- Across the below investment grade space, which now offers yields ranging between 7% and 9%, we are focused on higher-quality segments within sectors. For example, we favor BB rated high yield bond and senior loan issuers. Interest coverage ratios remain strong for these issuers, and they have staggered their debt maturities, thereby reducing refinancing risk at higher yields.
- Lastly, global macroeconomic risks today appear more balanced, a plus for emerging market (EM) debt. Many EM regions and countries still exhibit supportive growth levels, and some key EM central banks have begun cutting policy rates.
“We think it makes sense to extend duration and focus on attractive credit sectors in fixed income markets.”
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All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Equity investing involves risk. Investments are also subject to political, currency and regulatory risks. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, derivatives risk, dollar roll transaction risk and income risk. As interest rates rise, bond prices fall. Below investment grade or high yield debt securities are subject to liquidity risk and heightened credit risk. Foreign investments involve additional risks, including currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks may be magnified in emerging markets. Asset-backed and mortgage-backed securities are subject to additional risks such as prepayment risk, liquidity risk, default risk and adverse economic developments. Preferred securities are subordinated to bonds and other debt instruments in a company’s capital structure and therefore are subject to greater credit risk.
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