Fixed income

Reasons to move cash back into bonds

July 17, 2024 - 8 min read

Matthew J. Eagan, CFA^®

Loomis, Sayles & Company

Brian P. Kennedy

Loomis, Sayles & Company

Matt Eagan, CFA^®, Head of the Full Discretion Team, Loomis, Sayles & Co., thinks we're in a higher-for-longer interest rate environment, and that's really being driven by some structural features that pervade the economic landscape. “Most importantly, the fiscal deficits that a lot of advanced economies are facing are structural in nature and related to demographics, security concerns, electrification, and the spending that's going on in those areas,” said Eagan. He expects these factors to be tailwinds for inflation and keep both real rates higher and inflation premiums higher as we go through various market cycles.

Pursuing value across all sectors and cycles

Loomis’ Full Discretion Team follows a bottom-up security selection process through all cycles – focusing on six investment pillars: Fallen Angels, Cheap for Rating, Upgrade Candidates, Stressed/Distressed, Avoid Losers, and New Issue Premium. “When we look at our six pillars throughout different market cycles, the most important one is Cheap for Rating, which is where the value is. We still see at any given point in time about 20% to 30% of the market offers Cheap for Rating. So, we're always harvesting those value ideas,” said Eagan. He added that Cheap for Rating is where his team does very well as bond pickers. Loomis’ experienced research team understands where the credit ratings may be headed, in some cases two to three years out in time. Also, he believes they are early at identifying those trends. This enables the Full Discretion Team to buy bonds at attractive prices and watch them get upgraded.

Six pillars of security selection

Fallen Angels: Forced selling by investment grade accounts pushes bonds below fair market value and inflates risk premium.
Cheap for Rating: Bonds trading cheap to fundamental credit risk tend to outperform.
Upgrade Candidates: The market is often slow to price potential upgrades because of short time horizons and distortions created by passive investing.
Stressed/Distressed: In our experience, prices for the lowest quality bonds become severely dislocated when the distressed ratio is elevated.
Avoid Losers: Avoiding permanent principal losses associated with value traps can add significant alpha.
New Issue Premium: New issues often come at a premium in order to attract investors to the primary market.

Upgrade Candidates, or rising stars, is another favorite pillar for finding interesting ideas in 2024. “As credit health remains very good at the midyear mark, we’re still seeing a decent number of upgrades. There have been a lot already moving up and out of high yield and into the investment grade market. We believe there is more to come. We are actually seeing a lot of upgrade activity going from single B to BB or BBB to higher BBB. So, we're trying to take advantage of that,” explained Eagan.

On the opposite end, he is seeing some interesting Stressed investments that appear to be a good value, trading at discounted dollar prices of $0.30, $0.40, or $0.50 on the dollar. “Your margin of safety is exceptionally good here. Those companies could actually restructure, and you may not get par back, but you might get a recovery that's very high off the trading cost today,” said Eagan. He is finding interesting investments in the Media Telecommunication and Communications sectors.

Adding duration to portfolios

Looking out several months, Eagan expects most of the Fed’s interest rate cutting will reduce yields mostly in the five-year area of the yield curve. And the curve, which is currently inverted, will steepen back out. “The longer end of the curve will be a place to get yield, but it's not going to have a very high capital appreciation. Yields will be roughly range bound from where they are today with the 10-year running around 4 to 4.5%. But now we think it's a good time to lean into that duration and try to capture that yield,” said Eagan.

Time to move cash back into bonds

Many investors may be questioning why they would give up a sure 5% from a money market or CD today. Eagan mentioned that this cash may seem attractive now, but it comes with risks – especially reinvestment risk if investors wait to redeploy cash after the Fed cuts interest rates. “History shows that a lot of people wait for the Fed to make the first cut. We’ve moved out our duration because we want to capture the good possibility of the Fed cutting rates this year. If you stay in cash too long, you’re going to suffer from what is known as 'reinvestment rate risk,'" said Eagan.

Yield reset spurs the return of multisector fixed income

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The information, data, analyses, and opinions presented herein (including current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) are for informational purposes only and represent the investments and views of the portfolio managers as of June 2024 and are subject to change and may change based on market and other conditions and without notice. This content is not a recommendation of or an offer to buy or sell a security and is not warranted to be correct, complete or accurate.

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Unlike passive investments, there are no indexes that an active investment attempts to track or replicate. Thus, the ability of an active investment to achieve its objectives will depend on the effectiveness of the investment manager.

Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise, bond prices usually fall), inflation and liquidity.

Credit risk is the risk that the issuer of a fixed income security may fail to make timely payments of interest or principal or to otherwise honor its obligations.

Interest rate risk is a major risk to all bondholders. As rates rise, existing bonds that offer a lower rate of return decline in value because newly issued bonds that pay higher rates are more attractive to investors.

High yield bonds are rated below BBB/Baa. Ratings are determined by third-party rating agencies such as Standard & Poor's or Moody's and are an indication of a bond's credit quality.

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