Where does fixed income go from here?
October 09, 2024
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5 min read
What does the Fed’s rate-cutting cycle mean for fixed income investors? How far might mortgage rates fall? Where are we in the credit cycle? Where might excess return come from? Could a more flexible approach add value?
Varying views on these questions, along with bond ideas, are captured below from a recent panel talk with fixed income experts Matt Eagan, Head of Full Discretion Team, Portfolio Manager, Loomis, Sayles & Co., Peter Palfrey, Portfolio Manager, Core Plus Bond Team, Loomis, Sayles & Co., and Adam Abbas, Head of Fixed Income, Portfolio Manager, Harris|Oakmark.
The Fed went big in September with a 50bps rate cut.
What’s your take?
Matt Eagan: We think this is going to be a shallow rate cycle relative to history. During past disinflationary periods, it wasn’t uncommon to see 400 basis points or 500 basis points rate cuts. And the long end of the market would have equity like returns. This time, I think you have to curb your enthusiasm.
We already got a lot of the return from the rate move. From here, I think it’ll be a steepening exercise. The belly of the curve should do well. It has better risk-adjusted returns. We think you are going to get most of the return in the five-to-seven-year part of the curve. Therefore, we are focused on that area, and we are biased towards decreasing our duration.
Peter Palfrey: We think that starting in early 2025, you are actually going to get a pretty substantial stepdown in inflation. And we think that by end of April, when we get the March data, we are likely going to be 2.1 or 2.2 for Core PCE (Personal Consumption Expenditures Price Index). And looking at the inflation rate ex-housing, Core PCE is likely to be even below target. I think that could get the Fed nervous because the Fed is very mindful of the fact that even in the forecast, we are expecting unemployment to go from the present 4.2% to 4.4% at the end of the year and drifting higher next year. They have a dual mandate. They have to be mindful of the inflation picture. And if the inflation data is cooperative, they have to address the labor side. They don’t want to see a downturn. So, I think the Fed’s probably going to surprise to the upside next year.
Adam Abbas: The question for me is what is the driver of rate declines and magnitude? I think Powell wanted to jump start with 50 bps and then it is going to depend on what the labor market looks like. We think it will be ok. This has really been more of a labor supply issue. It hasn’t been really an increase in firings.
Getting down to the terminal rate, I think it will be elevated. I think there are structural things in the economy, especially this fragmentation of global supply chains that matter. I think deficits do matter. The fact that you don’t have the government in there buying, putting a floor on assets matters. So in this new regime the neutral rate is somewhere like 2.5%. That makes sense to us.
Now shifting to what Powell said in September, I think it is bullish for credit versus rates. I agree that the belly of the yield curve will come down, but I think credit might be a place to be. We don’t need to see a major rewinding here. GDP still remains strong. You’re still probably looking at 2.5% over the next twelve months. Never before have we gone into a recession at the beginning of a rate-cut cycle with this elevated of GDP. So the important takeaway for me is we have a lot of cushion.
Where do mortgage rates go from here?
Palfrey: So there has been a pretty dramatic repricing of mortgage rates. But nowhere as much as we’ve seen in the 10-year treasury, which is the proxy for mortgage prices. Part of that is due to the lack of transactional activity. Another aspect of that is all major mortgage originators went through a huge layoff period from peak levels in 2021-2022 to the present period. They have cut 50% of their staff they had prior to Covid, creating a capacity constraint. Because of that, mortgage originators are not being aggressive. This is one of the reasons why mortgage spreads have stayed really high. With that said, we think mortgage rates will be tracking the 10-year part of the yield curve.
We think that as you get lower interest rates, you will get more activity in the housing market. That should cause these mortgage originators to step up employment – and get more paper out there. And they'll be competing once again. But ramifications for the housing market we think will be limited. Nationally, we think house prices have probably peaked and are likely to drift lower as you get more supply back in the market.
How is deglobalization and other structural shifts impacting markets?
Eagan: We don’t think globalization of trade is going to disappear. We think trade is reordering between two spheres: China and the US and its western allies. What I worry a lot about is trade protectionism. It can be inflationary, but also a real drag on economic growth. So we have to watch closely and see how it plays out. We will see how the elections work out, etc. And, you know there is nearshoring and friendshoring – as some people call it. Look at the chip war and where plants are being built.
Times are changing. There are structural factors that we believe are going to have tailwinds for inflation and keep real rates higher. The big one is deficits. Politicians don’t care about deficits. We’ll see how long that lasts when the bond vigilantes show up. But the US deficit is an inflationary factor. It is being driven by demographics of an aging population and security issues, as global tensions build, especially between China and the US, to name a few factors.
How are you looking at the credit cycle and credit sectors?
Palfrey: We spend a lot of time trying to determine where we are in the credit cycle and what’s driving it. From there, we construct portfolios from a top-down standpoint, looking at duration curve positioning, where the duration is coming from. It could be very different during different phases of the cycle. Presently, we’ve had a bias towards duration coming from the government sector, because we wanted to fully participate in the rally in yields that we’ve already gotten. In some cases, it’s been 130 to 180 basis points, depending on what part of the curve you’re looking at since the cycle high back in October 2023. But we also want to apply that duration to the right sectors. So right now, we favor a bias towards quality.
We have been in this expansion phase of the credit cycle for a very long time. In fact, over the past decade, we have spent about 80% of the time in the expansion phase. This is highly unusual. Historically, it’s averaged about 50%, so it is kind of an unusual period. But when you are late in the expansion phase of the credit cycle you want to be very mindful of where you are, and start going up in liquidity and quality, because the next step is typically a downturn.
Eagan: We believe that risk premium wears a well-worn path through macroeconomic cycles. There is a lot of data supporting that. We tilt into spreads. If you look at our portfolios, we like to get a lot of our excess carry and alpha out of the credit sectors. But we cast a very wide net. We tend to be benchmark agnostic depending on the product, but we’ll play the entire spectrum of fixed income sectors.
Looking at credit, we have six pillars that we view as our tailwinds within the fixed income space. They include Fallen Angels, Cheaper for Rating, and Avoid Losers. We apply deep fundamental analysis to do our homework on individual credits. Getting that right and identifying the intrinsic value, an unbiased view of the intrinsic value of a particular security, and then observing where it trades and picking the cheaper priced ones in the market. We believe that a good investment framework is the key ingredient to a long sustainable track record of outperformance.
Do you think active management is critical for today’s markets?
Abbas: Really, the interesting aspect of our strategy is that in a world that’s going increasingly passive, increasingly benchmark driven, active managers like us can look for non-fundamental reasons, for things being marked to market lower, and take advantage of being opportunistic. So, we are fairly mobile and have a long-term horizon plan.
We are really bottom-up focused and concentrated. We run about 100 to 150 line-items versus the Bloomberg Aggregate Bond Index (Agg) with about 700 to 800. We do this because we want to provide attribution from our individual credit selection. If you understand the value philosophy of Bill Nygren and all Harris|Oakmark equity managers, that is the same core DNA. We built our valuation tool to focus on fundamentals over a longer time horizon. So, to the extent that inefficiencies continue to exist, based on non-fundamental flows coming into our marketplace and dictating mark to market, I think that is really the exciting opportunity for me.
Where do you get your alpha from Peter?
Palfrey: For our Core Plus Bond strategy, approximately 60% of our excess return comes from top-down macro views. For example, whether we are up or down in quality or what our government exposure is. We can look like the Agg if we want, or we can look very different if we want. When we look at long-term historical performance, we get about 45% of our excess return from the Plus sector (such as high yield, emerging markets, TIPS, and bank loans) allocations. Allocations to the Plus sectors are on average around 23% of the portfolio. So, we are tactical and can earn a lot of incremental return for the portfolio.
Overall, we view our strategy as more of an all-terrain vehicle, where you can avoid capital losses as you go from expansion to the downturn phase, and then have the tactical ability to go back into the risk markets.
What areas of fixed income do you like?
Abbas: I think there’s evidence that corporates in the investment grade index and the high yield index have better management teams and are more transparent today. Management teams have done a good job with extending maturities when the window was wide open, and it continues to be wide open. You also have businesses that are making smart capital allocation decisions. You don’t have a lot of leveraging transactions.
We see an incentive to move up in quality and find bonds that are dislocated and in the triple B minus or double B space. I don’t agree with the reaction to go out and buy triple C because the Fed came out and said, “Hey, we’re going to really focus on labor and employment”. Triple C credit, as we know, can be very idiosyncratic risk. And, they are for the most part, declining or over-leveraged companies. So, we prefer being in that triple B minus space, which has migrated maybe to a double B credit. Boeing would be a good example. I really think the best credit opportunities in my career have been distressed in the short run, but fundamentally strong in the long run.
Palfrey: From a cyclical standpoint, we are constructive on fixed income. We’re especially constructive on treasuries. We think that risk markets are fully valued at best. If you look at investment grade credit, right now it is at 90 bps over historical averages.
