Our Liability-Driven Investing team—Jesse Fogarty, Justin Rucker and Prashant Lamba—discusses U.S. fixed income markets and explores how pension investors can take advantage of higher yields, lock in attractive long-term discount rates and mitigate duration risk in their plan liabilities.
Do you think it is possible for the Federal Reserve (the Fed) to defy the odds and pull off a soft landing for the U.S. economy by lowering inflation without denting growth?
If we had to choose one word to describe the economy, it would be “resilient.” Inflation has begun to ease without a slowdown in growth. Indeed, growth has continued on an above-trend trajectory in 2023 despite U.S. policy rate hikes of more than 500 basis points (bps) in less than 18 months.
So, why has the economy remained so robust? Liquidity had already started to dry up, even before the start of Fed’s quantitative tightening and hiking program. Pre-pandemic, corporates had begun to strategically “term out” their debt maturities—replacing shorter-term with longer-term debt—to further strengthen their balance sheets. And, as the pandemic waned, consumers only gradually spent their high excess savings. As a result, both corporates and consumers entered the Fed’s rate-hiking campaign from a position of strength.
Furthermore, the optimism of the soft-landing scenario is consistent with previous late-stage rate-hiking cycles by the Fed: Disinflation occurs, but growth doesn’t roll over—at least not at first. We are now seeing a significant slowdown in the manufacturing sector, leading economic indicators are declining sequentially and credit is tightening in the bank lending channel.
We expect the Fed will remain restrictive until it reaches its 2% inflation target or the U.S. unemployment rate materially increases. We think tighter financial conditions will ultimately work through to the real economy, and recession risks are likely to rise by mid-2024.
What are pension clients looking to do in 2023 and beyond?
We have experienced the effects of historically high funding levels for our pension clients via our fixed income portfolio flows. Firm equity markets, despite significantly higher discount rates, provided our clients the flexibility to allocate to liability-hedging portfolios, a strong trend in 2022 that has continued into 2023.
In long-duration fixed income strategies, which are broadly analogous to liability-driven investment (LDI) markets, higher rates have translated into greater inflows into active mandates as well as passive long-duration government vehicles. On a base of approximately USD 1 trillion in total LDI assets under management in the United States at the end of 2021, net inflows of 6%–8% in 2022 were dominated by passive Treasury exposure.
Among our clients, we saw higher levels of activity in duration-hedging assignments as pension funds sought to capture the reshaping of the yield curve. And the implementation of the American Rescue Plan Act of 2021,1 which injected liquidity into the multi-employer retirement system, created powerful demand for fixed income assets. We believe that this incremental demand counteracted offshore investors’ weakened appetite for U.S. investment-grade corporate bonds as the costs of hedging U.S. dollar assets into local currencies grew prohibitive (Exhibit 1).
How do you see the environment for fixed income evolving now?
We are in a period of tremendous change: 2022 saw a rise in yields that most investors had never experienced in their working lifetimes. After yields breached 6.35% in October 2022, long-duration asset returns recovered somewhat, ending the year down approximately 25%–27%.2 In 2023, yields initially fell to 5%,3 but they have since broken through their 2022 highs. To put this in historical context: The last time yields were at these levels, which was in 2009, financial market conditions were very different.
Long credit markets continue to provide attractive entry levels. Returns for investment-grade bonds over similar-duration Treasuries have been resilient as well. After underperforming Treasuries by approximately 6% in March 2022, credit outperformed Treasuries in Q4 2022 and most of 2023 as spreads contracted significantly from a high water mark of 200bps in this cycle. Spreads for investment-grade debt4 remain historically tight, making the case for active management.
Looking forward, we expect solid demand for high-quality assets at these elevated yield levels as long as pension funding status remains robust. In our 2024 Long-Term Capital Market Assumptions, we published expected returns5 for long-duration assets: 5.20% for long Treasuries and 6.00% for long corporates, almost 350bps higher than our 2022 estimates for each. This shift means that—for pension funds to achieve the same level of expected returns that they have previously—asset allocations won’t need to work quite as hard.
However, we do expect modest risk taking to re-emerge in 2024 on the other side of any Fed-induced economic slowdown; pension investors with higher fixed income allocations would need to use the full toolkit to preserve and grow their plans’ funding status.
We expect solid demand for high-quality assets at these elevated yield levels as long as pension funding status remains robust.
What potential opportunities may emerge over the next 12 months to generate outsized returns vs. liabilities?
Investors need to remember that patience is a virtue critical to long-duration investing. Credit markets have rallied over the past few months, with the repricing reflecting only the most optimistic scenarios—there is no margin of safety embedded in the riskiest parts of long corporate spread market (Exhibit 2).
This late in the cycle, investors may win by not losing money, with important implications for portfolio positioning. We suggest:
- Adopting a higher-in-quality bias, running below-average spread sensitivity with higher allocations to Treasury and/or agency-backed debt (including securitized assets), as a surrogate for corporates
- De-emphasizing cyclical sectors, such as retailers, in favor of entities with regulated cash flows, such as utilities (including so-called “financial utilities,” or large banks) that are well prepared for extreme left tail risks
- In the event of a downturn, being ready to aggressively add high-quality corporate spreads to take advantage of the potential for forward excess returns and preserve liquidity in Treasuries as a funding source for more credit exposure at wider spreads
So what are we doing differently than traditional LDI investors? While remaining defensively positioned, we are emphasizing spread carry (income) instead of spread beta (price sensitivity) by buying low-spread duration assets at attractive yields. For similar average quality, these types of substitutions have the potential to add significant yield.
How do you see risks in commercial real estate affecting the securitized debt markets, especially long-duration assets?
Concerns about regional U.S. banks’ exposure to commercial real estate lending have been flooding the media recently amid tightening lending standards. Banks have, indeed, traditionally been big buyers of all types of residential and commercial mortgage-backed securities, including collateralized mortgage obligations (CMOs) and commercial mortgage-backed securities (CMBSs). Given the recent events with deposit outflows (and concerns around the unrealized losses on securities held on their balance sheets), banks have slowed the purchase of these securities, leaving the spreads historically wide to other asset classes.
Commercial real estate loans with any exposure to office space are now distressed assets. The work-from-home trend has led to a glut of office supply that will likely take years to resolve. We have largely avoided office exposure, preferring to invest in securitizations backed by multi-family and single-family rentals, which benefit from sticky rental rates.
Long-duration agency CMOs and agency CMBSs remain at historically wide levels due to the lack of bank buying. Longer CMOs and agency CMBSs are the highest-quality assets at spread levels that compete favorably with approximately 40% of A-rated long corporates6 (or better-rated indexes), with no downgrade or default risk. Further, we believe that consumer-backed securitized credit will provide enough structural protection, especially in the senior part of the deal structure, to withstand an economic downturn.
Active management of exposures is key to success when traversing securitized markets. Even modestly softer labor markets, should still allow for asset performance since subordinated cash flows can be used as a buffer to deleverage senior tranche positions in a given deal structure.