In brief

• Clarity on peak policy rates will alleviate rates volatility, while the return of positive real bond yields should make fixed income a prime candidate for a balanced portfolio.
• We see potential scope for credit spreads to widen as markets continue to price in greater odds of U.S. recession.
• Investors should focus on short duration, high quality U.S. fixed income. Securitized assets continue to present interesting opportunities and can diversify credit risk.

Fixed income markets have kick-started 2023 in a positive manner. While a hawkish U.S. Federal Reserve (Fed) and high inflation weighed on bonds in 2022, these headwinds have started to abate in  2023. Undoubtedly as rates peak and disinflationary momentum sets in, this will act as fodder for positive fixed income performance. For a more concrete outlook on the fixed income space, however, investors will want to look for further clarity in direction and destination of yields as well as assess the impact of slowing growth on spreads and defaults.

More concrete signs of a peak in yields needed

Despite the moderation in recent wage growth and inflation readings, the stronger-than-expected January U.S. jobs report, with nonfarm payrolls surging 517K, continues to signal labor market tightness. This means the Fed may hike by an additional 25 basis points in March and possibly even during the May meeting before pausing, bringing the Fed funds rate to the target range of 5.00-5.25%.

While futures markets are still pricing in a more dovish outcome and rates being cut heading into 4Q23, the Fed’s prevailing view is for rates to stay elevated throughout 2023. Should the Fed’s stance prevail over market pricing, this could lead to re-pricing which would exert upward pressure on U.S. Treasury bond yields in the near-term.

Thus, it may be difficult for the market to find its composure until investors have some visibility on when and where Fed funds rates will stabilize. Further clarity on peak policy rates as well as the path of inflation will alleviate rates volatility, while the return of positive real bond yields should make fixed income a prime candidate for a balanced portfolio.

Corporates and consumers are well positioned to weather a stormy economy

High yield and investment grade credit spreads have narrowed since the beginning of the year as concerns of a deep recession began to dissipate. That said, the U.S. economy is slowing on several fronts.

The recent decline in housing affordability has led to a retrenchment in housing activity. While weak housing market activity may not necessarily trigger a recession on its own, the combined effects of weakening netexports, continued fiscal drag and slowing corporate investments, may tip the economy into a recession later this year. Having said that, as the potential for a  late 2023 recession is so well-anticipated, it will likely be less disruptive than prior contractions.

Moreover, the banking sector remains resilient, and modest debt levels for both households and the corporate sector point towards only a shallow recession, instead of a severe one.

U.S. consumer also remain in pretty good shape. Despite negative real wage growth, consumers are still willing to spend, supported by the still-strong labor market conditions and more recently, falling energy prices.

Investment implications: Quality remains the name of the game

Looking ahead, we see potential scope for credit spreads to widen as growth slows further while markets continue to price in greater odds of a U.S. recession. Having said that, the spread widening within short -duration high quality investment grade credit may be relatively limited given elevated demand from investors, amid attractive yields. Technical supply factors also remain supportive with less large bank supply,  conservative balance sheet management and constrained mergers and acquisition activities.

Within high yield, even though overall corporate fundamentals are not under pressure and default rate remains low at 1.0% in January 2023 (versus 25-year average at 3.0%), high yield spreads could widen further due to rising concerns over corporate fundamentals, restrictive rates and technical factors, particularly as U.S. growth momentum slows further. We expect more divergence in the credit trend and there may be appetite for investors to position up in quality. A silver lining is that high yield fundamentals are healthy relative to the past. In 2022, U.S. high yield interest rate coverage ratio was at 5.7x - its highest point in 10-years - and sharp deleveraging has led to net leverage ratio moving back below its long-term average.

Meanwhile, securitized assets such as agency residential mortgage-backed securities (RMBS) as well as agency commercial mortgage-backed securities (CMBS) could help investors pick up yield while managing risk. They are issued or guaranteed by U.S. government-related bodies and can demonstrate defensive characteristics given their low risk of defaults.

Exhibit 1: Spreads

Basis points, option-adjusted spreads

Source: Bloomberg L.P., J.P. Morgan Asset Management. Data reflect most recently available as of 07/02/23.

Furthermore, real estate developers have accumulated considerable operating income in the past several years, as the sharp increase in residential rental income and shorter lease terms have allowed properties to increase rents and cash flows in accordance with higher inflation. This should continue to support fundamentals and point to relatively lower default risks. While spreads have been rising throughout 2022 (Exhibit 1), they remain at reasonable levels compared to previous episodes of slowing economic growth. Moreover, even though the demographics underlying housing demand continue to be weak, vacancy rates remain at historically low levels due to weak building activity while mortgage delinquency rates remain very low, giving us more comfort to include CMBS and RMBS as additional building blocks when it comes to fixed income.

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