Branstad: Hello. Thank you for joining us. I'm Jeff Branstad, portfolio manager with Thrivent Asset Management. This is Steve Lowe, our chief investment strategist.

Steve, let's talk a bit about the fixed-income market. What's your view on what's been going on there?

Lowe: Yeah, fixed income starts with the Federal Reserve (Fed) as they control short-term interest rates. The Fed started hiking last year and I think we're close to the end of the Fed hiking cycle. I think they have maybe two, possibly three hikes left before they pause. So, that brings rates up to about 5% or 5.25%, or a little bit higher. The reason they're pausing is they want to assess the impact of higher rates on the economy and their intention is to hold rates high for all of 2023. If you look at their own projections, their intent is absolutely to defeat inflation. They don't want to repeat the mistakes of the 70’s, where the Fed backed off too soon and saw inflation go up again, because that is much more damaging in the long run than holding rates higher and ending up with one recession.

I do think that they will end up cutting later in 2023, earlier than expected. Part of the reason is that rates are already well above neutral, and they are slowing the economy. You can see inflation coming down, you can see the economy already slowing. If inflation is stickier, I think they're going to raise rates a little bit higher and hold, maybe into 2024. We don't think that [will happen]. We do think that they will be forced to ultimately cut in 2023. The other point I think that's important about the Fed is that they are willing to risk a recession. Powell has been clear; he's spoken about how “there will be pain,” as he has put it, because I think there's more damage in the long run if they don't defeat inflation the first time. So, they're determined to do that.

Branstad: What would your outlook on Treasury rates be, then, in this environment?

Lowe: I think Treasury rates will head lower, particularly long rates. They've already [come off from] the peak. I think we've probably seen the high or close to the high in long rates. By that, I’m referring to ten-year Treasuries. We internally started moving toward a neutral position on duration or interest rate risk last year after being underweight for most of 2022, because I think we are getting closer to the peak and that long-term rates will be increasing, driven by recession fears or the economy slowing and lower inflation.

One of the key points about our fixed-income outlook for this year is that we're increasingly comfortable taking interest rate risk, particularly in the longer end. If you look at the Treasury curve, I think it'll flatten further as [the Fed goes] through their last hikes. That’s just mechanical; short-term rates will come up, but you'll start to see the curve steepen ultimately as the market, into this year, starts pricing in the chance of a recession and starts pricing in more chances of the Fed cut. Under that scenario, you'll see short-term rates come down. So, we think the front-end of the Treasury curve will be particularly attractive for investors, because short rates in that scenario have a fair amount to rally, particularly if there is a recession. And we think a recession is more likely than not.

Branstad: So, I think that's a good segue into talking about credit, which is obviously going to be impacted if there is a recession.

Lowe: Yeah. Credit offered very attractive yields toward the end of 2022. They're a little bit lower, but we still think they look very attractive – you haven't been able to get yield for years in the fixed-income markets. I think that's one of the reasons why you saw credit spreads rally into the end of 2022 as people were taking an opportunity to add yield to their portfolios.

So, looking into 2023, I think I would rather stick to high quality and take some duration risk with that than take a lot of risk at this point in lower-quality credit. By that, I mean high yield and in particular leveraged loans. So, we do expect the economy will slow and that will drive down longer rates, as we said. But that also will push up credit spreads ultimately.

We like investment-grade credit right now. I think the risk/reward of it is very attractive – it will benefit from lower long-term rates. But in a recession, it's still high-quality companies by and large, so you'll be better off than you would be in lower quality.

I think preferreds look very attractive right now. Most preferreds are issued by banks. Banks are in much, much better shape now than they were heading into the Great Recession; they had very high capital levels and preferreds would also benefit. They also tend to be very rate sensitive, so they’ll benefit from lower long-term rates.

Another asset class that is impacted by higher rates and could benefit from lower long-term rates is emerging markets debt. There, you have rates as a tailwind versus a headwind. The other tailwind is a weaker U.S. dollar, which tends to help emerging market countries. Emerging market central banks were very aggressive in reacting to inflation. They’ve got high inflation or even higher inflation because the dollar caused imports to go up in price for them. But also, they're further along in the hiking cycle, poised to ease earlier as inflation tails off and the economy recovers. So, we think emerging markets could do well as the global economy [recovers], particularly later in the year, but also lead markets as the global economy recovers.

The other key area of credit is high yield. It's a good buy-and-hold for yield. I think there will be an opportunity to buy them cheaper than they are right now. It tends to be economically sensitive, so you're worried about defaults there. One thing about high yield is that it's much higher quality than it used to be. There's a record level or near record level of BB’s, which is the top rating. A part of that happened during the pandemic – a lot of investment-grade companies got downgraded, so the credit quality is better. I think that, even if you had a recession, defaults are probably 4% or 5%, maybe a little bit higher, and they've been at record lows for the past few years. Where we would be interested is spreads of about 600 basis points – that would be attractive. Where we would be very aggressive is at about 800 basis points because, historically, when high-yield credit spreads get that high, you've almost always made money over a one-year basis just from the power of the high income, partly.

The one area that we are cautious on is leveraged loans. If you look at that universe, it’s a very poor credit quality universe. It’s much poorer than it used to be. There are a lot of private companies, so it tends to be very leveraged, and the credit quality has deteriorated pretty significantly. And then, from an investor flow point, leveraged loans do well when rates are high because they have floating rates and you won't get that tailwind to leveraged loans if long-term rates go lower. So, we're a little bit leery of leveraged loans.

And then if you look at what we call alternatives, I think closed-end, fixed-income funds will look attractive, particularly as we get further into 2023.

Branstad: So, it sounds like there are opportunities out there. Maybe a little bit further down the road, but definitely some things that the team is focusing on.

Lowe: Yeah, absolutely.

Branstad: Thank you all for joining us today. On behalf of Steve and myself, we appreciate you tuning in. Goodbye.

Lowe: Thank you.