Gain insights on how to position fixed income portfolios for yield and ballast given mixed signals on consumer health and policy outlook.
As investment managers, we are often asked how we are positioning client portfolios given the economic uncertainty in today’s markets. Based on our outlook across asset classes and fixed income market sectors, here is a summary of our current views:
On the economy, we see conflicting signals in the data that make the path ahead opaque. Metrics like rising credit card delinquencies and auto loan defaults suggest mounting household balance sheet strain. However, retail sales have come in stronger than expected lately, implying some ongoing resilience of the U.S. consumer. For now, the economic glass seems both half empty and half full. With credit spread valuations still relatively stretched, caution is prudent at this mature stage of the economic cycle. Investors should aim to stay nimble and react quickly until more definitive trends emerge.
Using Duration for Ballast
To help anchor portfolios against volatility, we believe in using duration to add ballast. After an extended period of extremely low yields, current nominal and real interest rates now provide an attractive level of income in many segments of the fixed income markets. Maintaining above-average duration for client portfolios helps buffer against capital loss risks if the economy deteriorates further from here. The Federal Reserve is almost certain to deliver a cut in September, though a still unfinished inflation fight may keep them from being too aggressive over the next several months. Intermediate-term yields could stay range-bound in such an environment, though the risk/reward still skews toward rates falling versus going higher.
Balancing Income and Defense Across Credit
Across credit sectors, investors should focus on a barbell approach – hunting for incremental yield opportunities toward the front end of yield curves while also using exposures further out the curve to help defend portfolios. In the asset-backed securities (ABS) market, for example, senior bonds are high quality and have short maturities, which means a limited yield give up versus more credit-sensitive ABS bonds out the yield curve. Meanwhile, in high yield, credit spreads remain inside their long-term historical averages. While select opportunities exist, this is not yet a “back up the truck” moment to aggressively add high yield risk. As the economic cycle continues to progress, the weakness we noted earlier about the consumer warrants a judicious approach. But certain segments, like non-qualified mortgages (“non-QM”) within the RMBS market, still offer attractive yield profiles, low loan-to-value (LTV) ratios, and a higher quality underlying borrower base less likely to deteriorate in the near term.
Evaluating Commercial Real Estate and Emerging Markets Debt
In commercial real estate, prime property subsectors such as downtown “Class A” office space appear attractive from a relative value standpoint, but overall, CRE fundamentals are not at a level we would like and we believe investors should remain cautious. Outside the U.S., in emerging markets debt, pockets of value have emerged in countries with high real rates and the potential for currency appreciation as U.S. dollar strength loses steam.
Muni Market Technicals and Relative Value
Within municipal bonds, current technical factors look supportive as investor demand remains strong against a backdrop of rising supply. Year-to-date issuance is up around 30%, while robust appetite for munis has largely kept pace.
However, some headline risks exist around potential tax policy changes that could impact the market’s tax-exempt status. As this is an election year, discussions around eliminating or limiting the tax-exemption have resurfaced. So far, we view this more as noise rather than a high probability of actually happening. The latest campaign rhetoric has yet to directly target muni tax exemptions in a significant way.
Fundamentally, the municipal market’s diversified issuer base and lagging reaction to economic weakness help insulate against credit problems. For example, even as mortgage, credit card, and car loan delinquencies rise, municipalities provide essential services, where revenues tend to suffer later than those of households and corporations. Unemployment trends do bear monitoring for their impact on state and local budgets. But overall, munis are generally among the last to feel broad economic pains.
Looking Ahead
As we look to the remainder of 2024, questions about Fed policy action, the upcoming U.S. election, and the growth/inflation path will continue to provide both market opportunities and risks. This perspective informs our overall view, leading us to believe investors should pare back credit risk across portfolios while thoughtfully extending duration to help endure periodic volatility. Investors should continue seeking incremental yield opportunities but in a defensive posture, maintaining flexibility to react nimbly as market risks and rewards evolve.
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