PM Corner: In conversation with Cary Fitzgerald
Cary Fitzgerald, portfolio manager of J.P. Morgan’s Short Duration Bond Fund and Short Duration Core Plus Fund, discusses bond market opportunities at a time when the indicators seem positive for investing in high-quality fixed income.
A diversified allocation to high-quality short duration bonds and the ability to be nimble during periods of volatility should help us deliver strong risk-adjusted returns to our clients.
Markets have rallied on a softer U.S. inflation report and central banks’ guidance that rate hikes will slow. What’s your macro view?
If we boil it down, 2022 has been all about inflation and central bank policy response. Markets have had to grapple with inflation data that showed no signs it was cooling, and central banks tightening interest rates aggressively while signaling more of the same. Finally, in November, we saw encouraging developments in both. While inflation data globally remains hot, the European Central Bank, the Bank of England and the Federal Reserve (Fed) are now guiding markets toward a downshift in the pace of rate hikes.
Monetary policy operates with a lag, so it’s appropriate to allow time to assess rate hikes’ impact on the economy and inflation. We welcome this, but we also need the inflation data to cooperate. That’s why the November report, of softer U.S. inflation in October, is so meaningful. One economic report does not make a trend, but its details – along with declines in other leading inflation indicators – give us confidence that inflation pressures should start to cool in the quarters ahead.
What are the implications for bond market opportunities?
We think the stage is set for strong fixed income returns. The magnitude and longevity of the bond sell-off this past year paralyzed many clients. Many of them sought safety in cash. We believe that finding a peak in inflation, and in the pace of rate hikes, can help reduce interest rate volatility. Cooler inflation and slower monetary policy tightening would benefit bond markets and should give clients the confidence to invest in bonds again, particularly given how high yields are today.
The markets underwent a seismic shift in 2022. How should investors be thinking about fixed income now?
What a difference a year makes! A year ago, the 60/40 stock-bond portfolio was left for dead. Bond yields didn’t deliver the income clients needed or the downside protection they’d hoped for against riskier assets. Today, we expect significantly higher yields and core fixed income returns of 5%-6% over the next 10 years.1 Clients may now attain their investment return objectives with considerably less risk. When 2023 allocation plans are discussed, we expect a new emphasis on fixed income.
Also, our economic outlook for 2023 is negative. A recession is likely, which would cool inflation toward the Fed’s and other central banks’ targets. Recessionary environments are typically times when high-quality fixed income performs well. We would expect core fixed income to be a primary focus in a period of weaker growth, given that’s when investors worry about riskier assets’ performance.
Some clients “hid out” in short Treasury bills with laddered maturity dates during this period of volatile markets. How does this compare to an active, multi-sector, short-duration fixed income strategy?
Negative returns in all asset classes pressured many clients toward those approaches. The thinking was that you wouldn’t incur a loss if the bonds were held to maturity. This logic made sense but also limited the income and return potential of clients’ fixed income allocations.
Shorter maturity Treasury bills are beneficial when interest rates are rising – but can be a drag on returns when yields fall because at maturity, the proceeds must be reinvested at lower yields. For clients with longer investment horizons, we think current interest rates are at an attractive level to start locking in for longer.
And in a year when all types of bond yields have risen significantly – spreads of corporate bonds, agency mortgages, asset-backed securities, commercial mortgage-backed securities (MBS) and others have all widened – Treasuries have risen the least. That suggests significant opportunities in these other sectors. We believe a diversified investment approach, across fixed income sectors, will provide stronger risk-adjusted returns.
Dramatic bond market volatility has also created significant opportunities for active management. Our diversified short-duration strategies use active asset allocation and security selection decisions to capitalize on the current market environment. Last year, we significantly reduced risk across duration, credit and agency mortgage exposures. Now we have the flexibility to add back at much more attractive levels.
Investors used to set their bonds based on the “30-day SEC yield” calculation – but that isn’t working anymore. What should they use instead?
Thirty-day SEC yields, a measure regulated by the Securities and Exchange Commission, have been closely aligned in most market environments to the average yield to maturity (YTM) of the bonds held in fixed income funds, giving investors accurate return expectations. But the alignment broke down in 2022. Interest rate volatility exposed some significant flaws in this calculation. It has become much less relevant and can lead to poor decision-making.
We encourage all clients and advisors to focus on YTM (less the appropriate share class fee) – sometimes labeled the “reporting yield.” This reflects the current average yield of bonds held in a fund at today’s prices. It’s the best indication of future return expectations.
With today’s macro backdrop and an inverted Treasury curve, what are your best global fixed income investment ideas?
We see very attractive investment opportunities in high-quality bonds. We have a preference across global fixed income for high-quality short maturity bonds, such as investment grade corporates, agency MBS and other high quality securitized credit including asset-backed securities.
The yield curve is normally upward sloping, requiring investors to take more risk for more income. Today, with the yield curve inverted and high quality bond spreads wider, it’s an attractive environment to find opportunities to maintain – or, in some cases, increase – yield with a low-risk profile. The 1-year to 3-year maturity range is offering the most attractive interest rates across the curve. Our short duration strategies are focused here.
With recession risks growing, we prefer securities with less credit risk and less price volatility. Our diversified portfolio starts with a foundation of traditional high-quality fixed income and layers in extended sectors. We also maintain diversification with Treasuries and agency mortgages.
In strategies that allow high yield, we have significantly reduced our allocation as we prepare for weaker growth, and because we recognize that high yield spreads have outperformed higher-quality fixed income.
Overall, you could say that our best idea is our strategy: A diversified allocation to high quality short duration bonds and the ability to be nimble during periods of volatility. We believe that should help us deliver strong risk-adjusted returns to our clients.