Rick Figuly, lead Portfolio Manager of the Core Bond Strategy, discusses the latest in bond investing, including the inflation and rates outlook, opportunities in agency-backed securities and commercial real estate valuations.
As market participants debate what lies ahead—recession or no recession, soft landing or hard landing—how do you think about positioning an investment-grade, high-quality core bond portfolio?
One of the key tenets of core bond investing is that the portfolio’s duration not drift too far from the benchmark. Typically, that means staying within 10% of the benchmark index’s duration.
As to the recession question, while the massive increase in interest rates is likely over, it seems unlikely we will see a significant rally in core bonds in the near term. The market seems to agree and has largely priced out rate cuts, or the prospect of recession, during the remainder 2023. The Federal Reserve (Fed) remains steadfast in bringing inflation back toward its target. And while many leading indicators are pointing toward recession, the economy has been resilient, particularly on the labor front.
We believe that interest rates will fall—but the timing remains uncertain. As long-term investors, we are comfortable exercising patience. It’s our belief that monetary tightening’s cumulative and lagged impacts are still filtering through the system. Some of its impact has yet to show up in the inflation data, particularly in housing. Clearing the massive fiscal and monetary stimulus of recent years may take more time but we are confident that the Fed has the tools to achieve it.
That said, achieving the Fed’s goal may come with consequences. Bringing inflation back toward the 2% target1 will require a material softening of the labor market and it is questionable that the Fed can achieve this without generating at least a mild recession.
With the Fed and other central banks halting their purchases of agency mortgage-backed securities (MBS), are you finding value in this market?
Agency mortgages may have started to look more compelling as we approach the end of this rate hiking cycle. MBS also typically do well, relative to investment-grade alternatives, leading up to a recession, which is still our base case.
When we think about cross-sector relative value, in the context of higher rates and the impact of Fed policy, we have seen that MBS spread tightening has lagged investment grade (IG) corporate spread tightening. The lag has been due mainly to the supply-demand dynamic—you noted the central bank exiting its purchasing program. And increased rate volatility has kept other investors on the sidelines.
At these levels, we prefer higher-quality agency MBS over parts of the IG corporate market, for the spread advantage, and because agency MBS are high in quality. People still need, and are paying, their home mortgages, but in a recessionary context corporate earnings might become compromised.
A theme for us is to build a diversified agency MBS allocation with more attractive risk-return profiles than the benchmark index. (The index comprises mainly current coupon and lower coupon MBS.) The challenge is finding the attributes we want at the right price. That takes time, patience and expertise.
Commercial real estate valuations have caused concern. Describe some of the team’s work there and the team’s current view.
While we remain cautious on commercial mortgage-backed securities (CMBS) overall, some corners of the market still look attractive. We have avoided office and retail CMBS because so much uncertainty remains in that area or we have been more selective on tranche, deal structure and loan mix. Core bond strategies have historically de-emphasized traditional CMBS exposure, such as single-asset, single-borrower conduit deals,2 and that is typically where you find many, or most, of the office and retail store properties.
Instead, our focus within CMBS has been on subsectors tied to the strength in residential housing—such as single-family rentals. In residential sectors, we can benefit from the equity built up in older housing deals as home values have appreciated. And in residential rental, rental income is higher today and we think these levels should be sticky, first because of the housing shortage due to the under-building of homes; and second, people should be drawn to renting because persistently higher interest rates should continue to make home ownership less affordable.
The consumer continues to weather high inflation and the fight to tighten financial conditions.
How do you weigh the consumer’s financial health when you assess the securitized opportunity set?
As the risk of recession looms, securitized credit, such as asset-backed securities (ABS), can be an important diversifier in bond portfolios. ABS look attractive in this rising rate environment as they tend to have significantly shorter duration—meaning they are less vulnerable to interest rate fluctuations. ABS also provide income, and their credit quality can naturally rise—what we call positive credit migration—increasing the portfolio’s credit quality. And there are diversification advantages. For us as active managers, ABS fills out our tool kit.
Today, our largest exposure in securitized credit is to consumer loan-backed ABS. The consumer continues to weather high inflation and the fight to tighten financial conditions. Given that we are in a late-cycle environment, we prefer taking shorter-duration credit risk in consumer loan-backed ABS.
Based on historical patterns, current investment grade corporate spread levels suggest the market sees a low chance of recession. Are you still finding value at these spreads?
This is an interesting one. The market is not pricing in a high likelihood of recession. Option-adjusted spreads for investment-grade corporates sit at around 126 basis points, near a 10-year average.3 Those spreads are far lower than they were historically, before recessionary periods.
Yield tells a much different story. The average over the past 10 years for investment-grade corporate bond yields has been around 3.3%. However, current yields are around 6.4%4—near the highest since the global financial crisis. I think for many investors, yield is a bigger draw than spread, so they are adding back IG credit. It’s likely this renewed interest is containing spreads, more than they would otherwise be late in the cycle.
Overall, we are cautious about corporate credit and prefer to be slightly underweight. We believe certain sub-sectors within IG corporate credit do present good value, relative to the risks we have identified. On that list are large non-U.S. banks at the short end of the curve, and utilities at the longer end.