Branstad: Hi, everyone. Thanks for joining us today. I'm Jeff Branstad, a portfolio manager here at Thrivent Asset Management. With me is Steve Lowe, our chief investment strategist. Steve, I know you've got an extensive background in fixed income. I'd love to get your views on what's going on with that market. Let's start with the [Federal Reserve, or] Fed.
Lowe: 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.
Branstad: So, what kind of risks would challenge this viewpoint?
Lowe: 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.
Branstad: So how would you describe Thrivent Asset Management's view on fixed income right now?
Lowe: 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.
Branstad: What does that mean for rates, then?
Lowe: 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.
Branstad: Yields right now are higher than they've been for quite some time. Where should an investor be going with the inherent risks in the market? Where should investors be going to get yields right now?
Lowe: 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.
Branstad: So, let's drill into your views on the credit space and some of the differences right now between investment-grade and high-yield bonds.
Lowe: 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.
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.
Branstad: Yeah. So, how about some other spaces in the fixed-income markets, like maybe loans or [emerging market] debt?
Lowe: 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. So, we're concerned about defaults and credit quality in a slowing economy.
[Emerging markets, or 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 [Bank’s] failure, and particularly larger-cap banks are very well-capitalized. And we think those look attractive.
Branstad: So those you would expect to bounce back.
Lowe: Yeah, they have already. But we think there's more room. They're still pretty cheap.
Branstad: That's great. Another round of great information, Steve. Thank you so much. And thank you all for joining us here to learn about Thrivent Asset Management’s views on fixed income. Thanks.