US bonds: Thinking beyond rates

Executive summary

• In an economic environment characterized by rising interest rates and slowing growth, fixed income has emerged as a beacon of opportunity.
• The historically unusual conditions that have weighed on the US bond market have created a high degree of uncertainty and intermittent volatility.
• Bonds have grown more attractive over the course of this year, given the carry available from high nominal rates, reasonable credit quality in both investment-grade (IG) and high-yield markets, and the flexibility of active managers to maneuver opportunistically within and between sectors.
• We believe investment-grade corporates and better-rated high yield, supported by private credit and a nascent recovery in real estate, should deliver attractive opportunities heading into 2024.

The shifting sands of contradictory data releases, Federal Reserve (Fed) policy statements and inconsistent risk-on sentiment have repeatedly thwarted investors seeking clarity into the future path of interest rates this year. A sustained bond rally has yet to emerge, and the unusual conditions that surround the market make historical comparisons difficult. After all, we are only 10 months removed from 2022, the worst year for the US Aggregate Index since its inception.

For now, the tug-of-war between the market’s hunger for a Fed pivot and lingering concern that resilient US economic growth could keep rates higher for longer seems set to continue into 2024.  

Bumps on the road to a soft landing

The path of short-term interest rates dictated by a still-hawkish Fed has led the US economy to a fragile state where economic news can move yields dramatically in the course of a day. Volatility could be a factor in the near term as the Fed assesses the long and variable lags that policy changes will ultimately have on less interest-sensitive sectors of the economy.

While it appears we are headed into a period of slowing gross domestic product (GDP) growth, expectations of an outright recession have diminished. That said, slower growth will be reflected in both US Treasury (UST) yields and credit spreads. 

The Fed’s policy regimen has pointed the US economy toward a “soft landing,” but historically this outcome has been very difficult to achieve. Certainly, as much as the Fed would like to see a soft landing, it will default to something harder if the inflation and jobs data fail to cooperate.

A question that’s too often sidestepped now is what exactly will constitute a “soft landing.” Does that equate to flat GDP growth, 1% growth, or more? Or is this purely sentiment, i.e., we will just know it when we see it? Bear in mind that a zero-growth economy may be preferable to outright recession, but that doesn’t mean it will feel cuddly to investors after the rapid and sustained recovery from COVID-era setbacks. It’s reasonable to expect some volatility along the way as the market finds its way to a new equilibrium.

Fortunately, US Treasury (UST) yields at multi-decade highs have returned the power of income to the bond market. A large inversion of the UST yield curve throughout most of the year provided higher short-term UST bill yields compared to intermediate-maturity corporate bonds. This trend led to a “buy T-bills and chill” attitude with investors feeling no reason to take risks to enhance returns. But rising intermediate UST yields combined with corporate bond spreads are now attractive on both yield and income bases. Higher yields also provide a buffer to total returns in a scenario of continued rising UST yields or if credit spreads were to widen.

Credit spreads: still room for risk

Strong corporate fundamentals across the rating spectrum are supportive of tighter credit spreads and more durable returns than we have seen in prior cycles. Profit margins and revenues have been resilient as US economic growth and consumer spending continue to surprise on the upside.

What’s more, corporate management teams took advantage of lower all-in yields available over the past several years to push back against “maturity walls,” extending the period in which they will need to refinance debt and limiting the impact of rising rates on interest expenses for fixed-rate issuers. As a result, the day of reckoning many feared might come late this year has been pushed back toward 2025.

Of course, the benefits of those moves are temporary; companies will eventually need to access capital at prevailing interest rates. In credit, floating-rate leveraged loans will be the first to feel the impact. The trailing 12-month secured overnight financing rate (SOFR), currently around 4.6%, will be over 5% in roughly three months from now when fourth-quarter 2024 figures are being reported. That’s a situation where higher defaults are likely, particularly if rates continue for longer at current levels, rather than starting to trend lower.

Finding opportunity in the short term

Careful analysis of sectors and issuers will be key to identifying areas and issues that can still add value within a volatile interest-rate environment. We believe prudent risk management will be essential in constructing a portfolio that balances the opportunities in yield against the prospects for default.

Managers are also looking beyond rates and credit to see where they can further add value through portfolio allocation and trading efficiency, redoubling their focus on decisions where they can exert more direct control.

Thoughts on sectors

Investment-grade (IG) corporates (Joshua Lohmeier, Franklin Templeton Fixed Income) – We favor higher credit quality, given the slowing growth environment, leaning into sectors that demonstrate low spread volatility such as higher-quality utilities and pharmaceuticals.

High short-term rates have made Treasuries attractive versus intermediate IG corporate bonds with maturities less than five years. They also function as a convenient source of dry powder to reinvest when market volatility reveals better entry points. 

With regard to the credit curve flattening, all other things being equal, if one didn't have to own duration for whatever reason, that would help risk-adjusted returns. For institutional buyers with longer-term liabilities to cover, we would look to the higher quality part of the market to help compensate for the associated duration risk.

High yield (Bill Zox, Brandywine Global) – Non-bank financials represent an intriguing segment of high yield. With bank managements and their regulators and ratings agencies focused more on liquidity and capital than growth, non-bank consumer lenders and mortgage companies (among others) are in a better competitive position.

Utilizing bottom-up credit research, we steer away from companies that we believe have a higher probability of default or where recovery levels appear limited, which will compound losses following any adverse credit event.

Private credit (Mike Buchanan, Western Asset) - Private credit has seen tremendous growth over the last 15 years, yet there remain some underserved areas where private and public credit intersect. Smaller underwritten deals that larger institutional investors may have overlooked can be available at attractive prices with strong collateral packages. An uptick in financing for growth companies that pledge their intellectual property as collateral has added to the opportunity in the sector.

Value has also begun to rear its head in the commercial real estate market, where negative headlines and strong risk-off sentiment have beaten down pricing to a point that merits a second look. Naturally, we believe this requires prudent bottom-up analysis of properties and structures capable of generating attractive risk-adjusted returns while riding out some volatility.