Fixed Income Perspectives: Navigating the Economy’s Twists and Turns

Looking ahead, the most probable scenario we envision for the global economy is the avoidance of a banking crisis, yet the U.S. might still face a mild recession or a period of near-zero growth. As job markets weaken, inflation will likely take its time to taper off. Despite volatility in rates, the Fed will likely be hesitant to cut rates until inflation reaches its 2% target or there’s a significant dip in employment. Yet, even in this climate, quality yield investments will likely outperform.

The best-case outlook sees inflation quickly snapping back to 2%, with wage pressures easing. This means company profits won’t be squeezed, and consumers will continue to have spending money in their pockets. The central banks will be able to cut interest rates back to neutral. While not our base case, this environment would be good for all investments — rates, credit and equities would all rally.

If the banking crisis worsens, credit will tighten significantly. This will lead to a significant selloff in risk assets, fueled by growing fears of a recession. The good news for bond investors is that bonds will likely rally in expectation of Fed rate cuts, and bonds will regain their role as a portfolio diversifier.

Suppose the banking crisis is sidestepped but inflation worsens. In that case, central banks will have to maintain stringent monetary policy, leading to higher rates and tighter financial conditions in the near term. Not only will duration assets suffer, but such conditions will also lead to another leg lower for the equity market. Clearly, this is the worst of the four potential scenarios, but in our estimation, it is also the least likely.

Regardless of the economic weather, bonds stand as a beacon for investors because of:

• Higher yields: If the Fed decides to hike rates further, the high yields on bonds can act as a buffer against any detrimental effect on bond prices.
• Coupon clipping: If the Fed sustains high rates, the act of collecting regular bond interest payments (or “clipping coupons”) will lead to decent performance.
• Potential upside: Should the economy take a downturn, pushing the Fed to cut rates, bonds will rally. Negative equity performance will be partially offset by strong fixed income returns.

While the future of the economy remains uncertain, one thing is clear: Bonds are a flexible and resilient asset class, equipped to weather the varied forecasts.

Investment grade: 2Q earnings are surpassing expectations, and we are overweight telecommunications, utilities and technology.

High yield Growth: resilience and strong early earnings are overshadowed by concerns of slowing future growth and margin pressures.

Senior loans: We’re avoiding consumer-reliant issuers with weaker credit profiles, particularly those with a discretionary offering and exposure to a low- to mid-tier consumer.

Agency RMBS: Reduced Fed rate uncertainty and increased bank demand are expected to benefit MBS performance.

Securitized credit: Yields look attractive relative to comparably rated corporate bonds.

Emerging markets: China’s recovery faces property sector challenges and requires monitoring.

Investment grade corporates

• Investment grade (IG) spreads tightened to +112 in July amid easing inflation and strong growth and employment. Investors were keen on IG corporates, pushing weekly inflows to an average of $2.8 billion.
• Financials excelled, but adjusted for duration they remain cheaper than industrials. REITs, industrial products and basic materials saw notable earnings surprises, while energy, utilities and insurance lagged.
• 2Q 2023 earnings for about half of S&P 500 companies surpassed expectations, with signs of 2Q being this cycle’s earnings trough.
• We are overweight in telecommunications, utilities and technology, and we are market weight in energy.

High yield corporates 

• Recent growth resilience, moderating inflation, and a promising start to the earnings season have surpassed expectations.
• Despite current positive results, there is caution around potential slowing in upcoming quarters, with diminishing pricing power likely leading to margin pressures.
• While current rating trends seem stable (with notable rising stars emerging), the anticipation of weaker earnings growth and increasing interest costs could elevate defaults and stress credit quality.
• We are overweight in builders/building products, specialty retailers, energy (E&P) and specialty chemicals.
• We are underweight in cable/wireline, financials and technology

Senior loans

• Senior loans saw continued positive momentum in July with a 59 bp price increase, driven by supportive technicals, to a level of 94.83. Loan activities were primarily around refinancing and “amend to extends”, mostly from high-quality issuers, with a slight uptick in M&A/LBO actions.
• Despite the rise of secured bond issuance, challenges arise in the form of CLOs exiting their reinvestment periods, which affects some issuers/ arrangers due to syndication hurdles such as the inability to extend because of failing WAL tests.
• 1Q earnings highlighted themes of media & broadcasting underperformance, the slowing of margin pressures, and higher borrowing costs. While 1Q outcomes were better than anticipated, the approach remains cautiously focused on sectors such as packaging, restaurants and gaming/leisure, and wary of cyclical or consumer-dependent sectors.
• Risk assessment includes factors such as forward growth, downgrade risk and liquidity. At the issuer level, credit selection reflects expectations for weak forward EBITDA growth and the potential for lower fixed-charge coverage ratios. We are avoiding consumer-reliant issuers with weaker credit profiles — particularly those with a discretionary offering and exposure to a low- to mid-tier consumer, which should face the most downward earnings pressure in 2Q.

Agency MBS

• The projected net supply for 2023 is around $550 billion, mirroring the 2022 figures. Despite a downward revision of the initial $300 billion organic net supply projections, FDIC liquidations and Fed runoff should counterbalance this. The seasonality of summer months typically marks the height of production, which tends to wane during the fall and winter.
• The Fed maintains its “runoff” stance, and, while REIT demand is expected to surge in the second half of 2023, bank demand has experienced fluctuations due to regional banking disruptions and decreased C&I loan demand. Money manager demand, on the other hand, may remain robust or even increase throughout 2023 because of declining volatility, growing economic downturn risks, and positive fund flows.
• Factors such as reduced uncertainty regarding the Fed rate trajectory, the culmination of FDIC liquidations, and heightened bank demand are expected to favorably influence MBS performance.

Securitized credit

• CLOs: We prefer to stay up in quality, anticipating fundamental weaknesses in the loan market and increased credit risk as the economic cycle ages (despite CLO structural protections offering some buffer against default risk). The post-COVID favorable debt-service coverage ratios (DSCRs) for levered loan borrowers have become a risk factor.
• CMBS: Despite the stabilization of the banking crisis, the ongoing fallout in CRE financing poses risks, leading to tighter lending standards and potential near-term defaults, especially in offices. While some property types might perform well, sector-level underperformance will persist until financial conditions ease, which is not anticipated in the medium term.
• ABS: Consumer ABS offers a diversified, U.S.-centric mix with robust structures ensuring liquidity and short spread durations. Despite potential underperformance risks in sectors such as consumer loans and subprime auto (due to credit challenges for lower-income borrowers), ABS’s long-term outperformance potential remains high, especially in the context of a tightening economic environment.
• RMBS: Despite housing market activity below pre-Covid levels due to high rates, a brief price decline in 2H 2022 helped to balance supply and demand and to mitigate inflation. The market remains stable due to factors such as strong underwriting, high equity and a robust labor market, though there is credit risk in geographic areas with sharp price increases from 2021 through 2Q22, especially concerning non-QMs with affordability features.

Emerging market debt 

• China’s recovery has paused due to property sector issues, but a renewed policy focus on domestic consumption and a 5% growth target indicate potential stabilization. However, global impacts might differ due to several factors, including a contracting property market and no significant credit increase.
• While EM PMIs are stable, the overall growth outlook is muted for the year; LATAM and CEE growth is sluggish, but India and ASEAN demonstrate strong domestic demand.
• Inflation is declining across EM countries, with several LATAM and CEEMEA central banks ending their tightening cycles and reducing rates (influenced by easing DM inflation, a potential Fed pause and a stable USD). EM Asia remains on hold.
• LATAM faces heightened political risks, including transitions, rewrites and upcoming elections in various countries.
• EM corporate fundamentals are generally stable, but challenges include margin pressure from governmental interventions, high default risks in China’s real estate sector, and companies prioritizing bolt-on acquisitions over major debt-funded M&A.