The bond market is navigating a treacherous course between stubbornly high current inflation and the possibility of a future recession—a route made more difficult by uncertainty over Federal Reserve (Fed) policy and a nascent banking crisis. For some clarity on investing at this moment, we turn to Steve Lear, CIO of U.S. Fixed Income and one of our most experienced investors.
Jared Gross: Let’s start with the two foundational elements of economic forecasting: growth and inflation. Market expectations for growth remain positive, despite recent volatility. Do you think that there is downside risk to growth expectations, and if so, will that translate into meaningfully lower inflation?
Steve Lear: Since 4Q 2022, our base case has forecast a modest recession beginning in 2023. Our investment process is anchored by quarterly meetings of our entire investment team, including portfolio managers, research analysts and economists. The most recent meeting took place before the failure of Silicon Valley Bank, but we have been updating our views in real time since. We feel strongly that the additional headwinds created by more restrictive bank lending conditions will likely raise the prospects for an economic downturn (Exhibit 1). The impact will be felt most acutely in the sectors traditionally serviced by local and regional banks, including small business financing and commercial real estate lending.
More broadly, the challenge that some banks now face—potential losses on their portfolios of securities—is simply one manifestation of a more widespread problem: Much of the lending (and, by extension, fixed income investing) that took place during the low rate environment of the past few years is now generating negative returns. Some of these losses are captured by mark-to-market accounting, and some are not. Delayed recognition will likely prolong uncertainty and raise risk premia across the economy.
Against this backdrop, we think that inflation will continue to fall slowly but will have difficulty reaching the Federal Reserve’s long-term target level of 2% absent a recession. The timing and pace of this decline are far from certain, but we remain convinced that tighter monetary policy is slowing the real economy. This belief is grounded in two key elements: first, that current inflation is demand (not supply) driven, because demand has historically been responsive to policy changes; and second, that the impact of higher rates will be felt more strongly by an economy that until recently had been operating in an extended period of low interest rates.
Gross: Can you separate your fundamental view of the economy from the market’s pricing of the near-term path of rates? Over the past few years, we have seen several instances in which market participants projected a narrative that rates would fall, but they were repeatedly proven wrong. Is the market correct this time?
Lear: This is a key question. As active managers, we don’t simply accept the status quo level of interest rates. Rather, we must decide if the rates currently available make sense to us and represent good value for our portfolios. You are certainly correct that the bond market has contradicted the Fed’s policy path on a number of occasions, most likely due to investors having a more bearish fundamental view on the economy and possibly lacking conviction in the Fed’s policy stance.
We don’t necessarily disagree. Our view on growth and inflation is indeed more bearish than that implied by the Fed (Exhibit 2). However, on the second point, we are more willing to recognize the Fed’s conviction in keeping rates elevated—both at a higher terminal rate and over a longer horizon—to bring inflation under control. This leaves us in an interesting, though somewhat challenging, position: While a bearish fundamental view argues for more duration, recognizing the Fed’s more hawkish policy priorities may call for less.
As active managers, we constantly evaluate the relative value of different points on the yield curve against our expectations for the economy and Fed policy. To some extent, the current yield curve inversion, with long-term yields lower than those available on short-term debt, makes the decision easier: We can earn extremely attractive yields while enjoying the relative safety of short-term and intermediate maturities. Conversely, the market’s eagerness to price in a recession and future pivot by the Fed to cut rates can at times make longer yields relatively less compelling.
We continue to track these dynamics closely and have been positioning investment portfolios for the end of the cycle by employing strategies that will benefit from a steepening yield curve (as front-end rates fall) and by increasing overall duration.
Gross: When we look for risk in the bond markets, we must consider the potential for a negative turn in the credit cycle: Higher interest rates raise debt service costs, while a slowing economy reduces revenue. Yet many bottom-up, fundamental credit metrics suggest that borrowers are operating on a stable foundation. Do you have any concerns?
Lear: First off, credit markets are incredibly diverse and comprise a wide range of sectors beyond just corporate debt. An active manager running a credit strategy that makes use of a broad opportunity set can align the strategy with just about any fundamental view on the economy; it is simply not the case that credit is subject to a risk-on/risk-off mindset. Furthermore, credit managers must have the skill and resources to underwrite the individual credits within their portfolios. Credit risk tends to be asymmetric. In the best case, you get your money back with interest; in the worst case—default—you can lose most of your investment. Bottom-up research is essential. Passive credit investing is dangerous.
While our macroeconomic views are consistent with the potential for a negative turn in the credit cycle, our fundamental research across sectors and individual credits tells a more balanced story. Corporate balance sheets are generally in good shape, earnings remain relatively healthy, and inflation tends to diminish the burden of nominal debt across time.
I would also observe that the growth and expansion of the broader credit market has meant that many of the riskiest borrowers no longer tap the public markets at all. In recent years, the high yield market has seen ratings quality rise noticeably. Credit risk is now more likely to be concentrated in places like the leveraged loan and private credit markets (Exhibit 3).
Finally, the recent banking crisis has offered a powerful reminder that solvency and liquidity are very different risks. While the nature of holding demand deposits makes retail banks uniquely susceptible to short-term liquidity drawdowns, all borrowers—and investors—need to look closely at their access to liquidity in different environments. Longer term, however, the key risk is solvency: Is a particular operating business capable of supporting its debt burden in an environment of higher interest rates and slowing economic growth? We fully expect that many balance sheets throughout the economy will experience stress in the near future, and some will break.
Gross: When we think about opportunities in fixed income, we can start with the obvious appeal of short-duration high quality bonds, which are offering the highest yields now. As we extend outward with duration and credit risk, what areas look particularly interesting?
Lear: We bond investors fancy ourselves to be fairly cerebral types, so we’re not normally accustomed to using phrases like “no-brainer,” but the appeal of short- and intermediate-duration high quality fixed income is simply undeniable. Investors are getting paid to wait out volatility while remaining liquid—so much so that those investors can still pounce on future opportunities when they arise. It’s pretty tough to argue with that strategy.
Nonetheless, we do see some interesting opportunities to step out of the safest sectors and add potentially significant excess returns. I’ll highlight a few of these:
- Securitized credit offers diversification of risk across numerous underlying borrowers, self-amortization of principal across time, and (currently) attractive floating rates. While falling rates in the future would diminish the yields, there would be an offsetting effect from rising quality.
- We see value in portions of the agency-backed mortgage market. Seasoned low coupon mortgages issued a few years ago may be safe from refinancing risk but offer limited yield and carry. At the opposite extreme, recent-vintage mortgages at high coupons face elevated prepayment risk if the Fed pivots and interest rates fall. We prefer moderate coupons that capture yields in excess of duration-equivalent Treasuries with limited refinancing risk.
- Local currency emerging market (EM) debt is poised to potentially benefit from interest rate dynamics that reflect variations across business cycles. Many EM central banks began raising rates well in advance of the Fed and must maintain rates across time to compensate for historically lower credibility around inflation. U.S. investors can take advantage of the strong dollar to capture very attractive real yields in offshore markets.
As always, we seek to do what we have always done best: build portfolios bond by bond while managing risk across the broadest possible set of fundamental and macroeconomic factors. It’s a challenging time to be an active fixed income portfolio manager, but the opportunities are incredible. I’m excited.
Gross: Thank you, Steve.
In conclusion, we are balancing the increasing likelihood of a U.S. recession against the Fed’s current policy stance, which appears resistant to an early pivot—even if inflation remains on a slow but steady downward trajectory. Although we expect rates will resume falling at some point, market participants’ eagerness to get ahead of the Fed leaves us more conflicted about aggressively extending duration. Instead, we favor maintaining a relatively high quality defensive portfolio with selected use of more opportunistic allocations to drive returns.