Checking in on Q2 fixed-income trends, the factors driving performance, and what investors should expect going forward.
For a long time, fixed income was an uninspiring topic. Recently, that’s changed. And we’ve got an expert to tell you why.
From Thrivent Asset Management, welcome to episode 50 of Advisor’s Market360™. A podcast for you, the driven financial advisor.
In recent months, the typically quiet fixed income sector of the market has awakened and captured the attention of savvy investors looking for viable fixed-income investments to add to their portfolios. How are economic forces driving the performance of fixed income and what should we expect going forward?
To answer these questions and many more, we turned to Steve Lowe, CFA, Thrivent’s Chief Investment Strategist, who also has an extensive background in fixed income.
To kick things off, we got Lowe’s views on what's going on with the Federal Reserve, or Fed, and how its actions have greatly affected fixed income.
“A good place to start because most of fixed income starts with what the Fed is doing. So, the Fed is nearing the end of a very aggressive hiking cycle and they're likely to pause after they reach a target range of probably 5–5.25%. Maybe they'll do 25 basis points more depending on how inflation does, but they'll be well into an estimated restrictive range. In other words, they think they're actively slowing the economy at that level.
“Then the Fed expects to hold at what’s called the terminal rate for over a year, well into 2024. We doubt they make it that far for a couple of reasons. One, we think they'll be forced to cut probably later this year as the economy slows and most likely slips into recession. And we think inflation will also continue to moderate; it already has. You still have some really sticky elements to it, but it should cool further as the economy slows.
“A key to this view is that banks are also tightening lending standards. So, they're doing some work added on to the Fed. In particular, there are tightening standards across the board: for companies, for consumers, for real estate lending. You can see this in loan officer surveys and the failure of Silicon Valley Bank and the other banks. Those issues are most likely going to cause banks further tightening credit.”
As the Fed is slowly getting closer to its target range, it seems like rates have finally stabilized. Of course, the economy does not always behave in the expected manner. Lowe’s assumption is that rate cuts may happen later this year, but he does have one very big caveat. Yes, you guessed it—inflation.
“The key challenge to the Fed cutting rates is persistent inflation, that they will feel that they need to raise rates even higher and risk a recession, because not tamping down inflation in the long run is worse. There are really sticky elements to inflation right now. It's still very high, but there are a lot of signs that inflation is slowing. CPI, the Consumer Price Index, has fallen from 9% to 5% already. Goods drove inflation into the pandemic and those are coming down pretty sharply, like with computers, cars, and other things like online prices. Those are tracked and have started to roll over. Supply chain kinks and shortages have largely eased; freight rates are down. And finally, I would say producer prices, which are input prices, have fallen sharply, partly because energy is a component of it, but even core producer prices have fallen significantly.”
Any discussion of the Fed always comes around to their desire to curb inflation, even if it means pushing the economy into a recession. Lowe offers his insights into this delicate dance.
“Yeah, I think the slowing economy will push inflation down over time. Inflation is volatile when it's high, so it can move up and down. But we do think that the trend is down, and that will allow or force the Fed to cut in terms of the economy slowing significantly. And if inflation does persist, the Fed is just going to have to come back and raise rates higher. If they do that, that most likely seals a recession. They've been vocal about that tradeoff; they'd rather have a recession. They will let inflation get out of control.”
With these various scenarios in play, Lowe offered his thoughts on how the Fed’s actions could affect the rates of fixed income vehicles.
“We think that rates have likely peaked, at least long-term rates, and they will go lower into this year. And that's due to the slower economy and inflation because those are the key drivers of rates. We have moved from short duration – which is less interest rate risk – to neutral-to-a-little-bit-long duration, taking a little bit more interest rate predicated on rates falling because when rates fall, Treasury bonds go up in price – or other bonds.
“We've also started to shift from an inverted yield curve positioning – where you're betting on short-term rates going up higher than long-term rates – to a more neutral position and working our way to steepening, which typically happens before a recession, because ultimately the market prices in rate cuts, so short rates fall pretty rapidly. And when you see the curve steepening, that's typically a sign that you're possibly very close to recession or in one – unless, of course, there's a soft landing.”
Currently, yields are higher than they've been for quite some time. Lowe answered two important questions for investors. One, where should an investor be looking based on the inherent risks in the market? And two, where should investors be going to get yields right now?
“Yeah, I mean, yields are attractive, particularly if you look back to recent history. They're very attractive. The short end offers attractive yields because they're high, because the Fed's been raising it. So, you can actually make money on the short end of the curve. Our bias is to get yields from higher-quality [securities] because we're talking about the economy slowing, so we would do high quality, like investment-grade corporates, over high yield.”
You can’t talk about fixed income options without also discussing their corresponding credit risk. With his extensive background in fixed income, Lowe has some thoughts on when the higher credit risk is and isn’t a good idea especially when comparing investment-grade and high-yield bonds.
“Yeah, they’re somewhat tied to the rate market, too. What is more rate sensitive? I would rather take interest rate risk and high-quality credit risk than low-quality credit risk. To me, credit spreads, which is the compensation you're getting for taking risks like default risk, look rather rich. They're right around median levels right now.
“So, if we are going through a recession, you’re not getting paid for that right now. Specifically, investment-grade corporates – that fits with our bias for higher quality. They're more rate sensitive, stronger companies so they can withstand the downturn better than very levered companies. I would think that's good risk/reward there.”
When it comes to high yield bonds, Lowe remains fairly bullish. But he does have some important caveats for investing in high yield bonds especially with this sector’s volatility and the risk of defaults if the economy slides in a recession.
“High-yield spreads have held up partly because they have those yield buyers. High yield looks rich given the outlook. If you can buy and hold, the absolute yields are still pretty good, but there's going to be a lot of volatility. The opportunity is actually to buy at lower prices there because defaults likely do increase if the economy slows. We don't think they get to the extremes we've seen in the recent past, but maybe up to the 4–6% range. If you actually look at levels – the spread is measured in basis points or percentage points – if you get high yield around 600 basis points, that looks attractive. When you get up to around 8% or an 800 basis point spread, we would be very aggressive there because, on a forward basis, that has almost always worked out.”
So far, we’ve mostly discussed fairly standard fixed income options. But we also wanted to get Lowe’s opinion on some of the other flavors available in the fixed income space such as leveraged loans, preferred debt or emerging market debt – EM debt for short.
“Yeah, we’re leery of leveraged loans. They have deteriorated. They actually did well last year because of rising rates in absolute returns. But it's a very low-quality asset class and it's drifted lower quality. So, we're concerned about defaults and credit quality in a slowing economy.”
“EM has been helped by lower rates because it's a long-duration asset. So, what was kind of a headwind has turned into a tailwind for them this year.
“Looking at other areas: preferreds, particularly bank preferreds, suffered in the wake of Silicon Valley failure, and particularly larger-cap banks are very well-capitalized. And we think those look attractive.”
Thank you, Steve for your insights into fixed income. We hope he answered your questions about the opportunities and risks in this segment of market.
Thanks for listening to this episode of Advisor’s Market360™. All episodes are available on Apple Podcasts, Spotify, and Google Podcasts. Email us at firstname.lastname@example.org with your feedback, questions and topic suggestions for future episodes. And as always, you can learn more about us at thriventfunds.com and find other insights of interest to you, the driven financial advisor. Bye for now.
All information and representations herein are as of May 2, 2023, unless otherwise noted.
Any indexes discussed are unmanaged and do not reflect the typical costs of investing. Investors cannot invest directly in an index.
Past performance is not necessarily indicative of future results.
Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.
Thrivent Asset Management, a division of Thrivent, offers financial professionals a variety of investment products to help meet their clients’ needs. Thrivent Distributors, LLC is a member of FINRA and SIPC and a subsidiary of Thrivent, the marketing name for Thrivent Financial for Lutherans.