Higher-Quality Credit and Duration Offer Compelling Opportunities
What We Are Seeing
We are nearing the end of "synchronized" and aggressive global central bank policies to combat inflationary pressures.
After the Fed rapidly raised interest rates 375 basis points (bps) over the last nine months, their actions are having the intended effects: We see early signs of moderating inflation without a precipitous decline in economic growth.
We expect policymakers to deliver priced-in hikes but at a slower pace, with another 100 bps bringing us to a terminal rate of 5% to 5.25% by early 2023.
Slower growth coupled with a downturn in inflation should reduce interest rate volatility. In our opinion, high risk-free interest rates (which result in higher starting yields) create an attractive opportunity for fixed income investors — especially when coupled with potentially lower interest rate volatility.
Recession risk appears elevated in 2023 given the uncertain path of inflation normalization, growth dynamics and monetary policy reaction. We think high-quality, core fixed income duration, with high starting yields and strong balance sheet fundamentals, should serve as a strong hedge against these risks, while delivering levels of income not seen since the 2008 financial crisis.
We see wider dispersion in credit spreads in 2023 offering opportunities for relative-value strategies via active sector, industry and security positioning.
What We Are Doing
Given our outlook for moderating growth, elevated recession risk and receding inflation, we broadly favor overweighting higher-quality credit and duration while maintaining higher liquidity — areas that offer compelling valuations relative to history and lower-quality sectors.
We are overweight high-grade corporates, especially U.S. and EU investment-grade banks, prefer BBB versus BB non-financials and, on the margin, favor high-yield bonds versus bank loans for their duration and fixed interest costs.
We think the long-maturity corporate sector, where bonds issued by high-grade companies trade at significant discounts to par, offers attractive yields with positive credit convexity1 upside.
We are underweight non-financial corporates that are likely to suffer from slower growth, margin compression and higher funding costs.
We are increasing exposure to agency mortgage-backed securities (MBS), which have seen significant spread widening and should benefit from a decline in interest rate volatility and lower supply.
With household balance sheets in a historically strong position, we are taking a tiered approach to non-agency MBS (particularly collateral that has benefited from strong home price appreciation) and CMBS (focusing on hospitality and select industrials while avoiding offices).
Among asset-backed securities (ABS), we prefer senior tranches and collateral with "commercial" characteristics, and we are applying greater selectivity to consumer ABS (favoring better fundamentals in solar ABS, for example).
What We Are Watching
Labor market dynamics. The labor market is very tight and strong. Despite predictions, we have not yet seen a sharp downturn in growth from slower hiring and workforce reductions.
Corporate and consumer balance sheets. How dynamics will evolve as we experience lower growth and a moderate slowing in inflation.
China. How will ending zero-COVID restrictions impact supply-side inflation and global growth in 2023?
Ukrainian War. How does the dragged-out conflict impact EU growth and inflation beyond the energy challenges?
Vishal Khanduja, CFA
Co-Head of U.S. Multi-Sector
Brian Ellis, CFA
1 Convexity is a measure of the relationship between bond prices and bond yields, showing how a bond's duration changes with changes in interest rates.