Fixed Income Perspectives: The Fed pivoting to a pause, not to cuts

• Put away hopes of rate cuts in 2023 and get ready for “higher for longer,” provided jobs numbers don’t tank.
• The Fed’s “pivot” will be too little, too late as far as a recession is concerned.
• High-quality fixed income assets once again offer attractive income, reducing the need to reach for yield.

Markets have adjusted their definition of “pivot” to be a pause in Fed rate hikes rather than an outright cut. We’ve thought since the outset that the Fed would eventually pause for a prolonged period but would not actually cut rates for quite a while. Such abrupt reversals after a short interval are unusual. We believe the Fed will need to see a deterioration of the economy before reversing the direction of its rate adjustments, and with the economy exhibiting resiliency even after four consecutive 75 basis point (bp) hikes, that is unlikely to occur in the near term. That said, with financial conditions now in restrictive territory, we expect the Fed to soon moderate the size of its hikes before pausing altogether.

There’s a lot to be said for a steady income stream in a period of volatility. We expect volatility to last as the market grapples with uncertainty coming from the Fed. Once it becomes clear the Fed is done tightening, volatility should come down, leading to lower credit and mortgage spreads. In the meantime, we favor high-quality fixed income over riskier high-yielding issues. We don’t think investors are currently being paid enough to justify the risk of lower-rated bonds, especially if we enter a more obvious recession. In today’s environment, Investors can get more yield at lower risk (Exhibit 1).

The economic cycle is real, so don’t be surprised to see a mild US recession at some point in 2023. Jobs numbers could soften ― though probably not enough to justify a rate cut next year ― and corporate earnings growth is poised to slow. Nonetheless, a recession is unlikely to turn severe enough to materially raise default rates among investment-grade issuers. A steady Fed and a resultant decrease in volatility could help offset the impact of poor economic numbers.

Global rates: The Fed will keep hiking, but at a slower pace; we think we’re closer to the end of the rate hike cycle than the beginning and look for the Fed to pause early next year.

Investment grade (IG) corporates: Light supply and solid fundamentals lead us to favor IG credits over higher yielding bonds.

High yield (HY) corporates: Though outright yields are elevated we expect higher quality issues to outperform and prefer to remain underweight this sector.

Senior loans: There were no index-included defaults this past month, but the pace of downgrades is quickening as the outright number increases, leading us to favor higher-quality issuers.

Agency RMBS: With many of the headwinds that have resulted in poor performance YTD now in the rear-view mirror, agency residential mortgage-backed securities (RMBS) now offer attractive opportunities for high-quality yield.

Securitized credit: Non-agency RMBS remain one of our most favored subsectors as housing market fundamentals remain on solid footing; elevated issuance that has been a headwind YTD is expected to decline.

Emerging market (EM) debt: Despite various headwinds, EM corporate fundamentals remain solid, with healthy credit metrics.

Global rates and currencies

October was a challenging month for US bond markets, with yields continuing to climb during the month. By contrast, Germany’s bond market was much more muted, with 10-year Bunds rising only 3 bp over the month, compared to a rise in the US 10-year of 22 bp. Despite the widening yield spread, the US dollar index had its first negative month since May. This unusual combination underscores our central theme that we’re getting close to a Fed pause. Looking forward, we expect markets to home in on Fed pronouncements and comments from the various Fed governors, as well as a select few economic data releases, including the always important nonfarm payrolls report. The other data points of keen interest will be inflation and consumer spending, particularly retail sales. We expect economic data to be strong enough for the Fed to continue rate hikes, albeit at a slower pace. With the third quarter earnings season virtually behind us, though actual earnings were decent, forward guidance was more pessimistic than expected, highlighting a slowing economy.

Investment grade corporates

IG spreads were largely unchanged over the month as elevated rate volatility has held spreads under pressure, while light supply has provided some offsetting support. Although we remain somewhat defensive due to volatility, we do think IG bonds offer relatively attractive spreads given the overall high quality of issuers. In terms of specific industries, we prefer financials as a sort of hedge against higher rates, and we are light on energy-related issues given their strong outperformance over the past months.

High yield corporates

High yield bonds put in a remarkable performance last month, with spreads tightening across the credit spectrum. True to our outlook, higher-quality sectors performed better than their lower-quality counterparts, with CCC-rated bonds underperforming the broader HY index. At this point, BBs look fully priced. Overall, high yield markets continue to anticipate a mild economic slowdown but are not prepared for an outright recession. As a result, from a strategic point of view (6 months out), we’ve changed our outlook from Positive to Neutral.

Senior loans

Senior loans performed reasonably well during October, with the overall spread for the category contracting slightly over the period, leading to positive absolute returns. On a relative basis, however, senior loans underperformed most credit markets and remain challenging given technical and fundamental headwinds. Retail outflows have increased, though new issuance has slowed, giving some support to loan markets. New primary issuance for October totaled a low $5.7 billion.

Default activity was nonexistent in October, and the trailing 12-month default rate was a much lower than average 0.83%. Unless there is a material worsening of macroeconomic conditions, we expect default rates to remain on the low side. On the other hand, downgrade activity is increasing, with the three-month rolling downgrade to upgrade ratio moving up to 2.47x from September’s 2.28x. We’ve happily increased our BB-rated exposure while selling weaker credits over the past several months.

Agency RMBS

Agency RMBS has materially underperformed YTD as new supply remained elevated, rising rates have led to duration extension, and concerns over Fed sales and elevated rate volatility weighed on spreads. Now, however, all of these headwinds will likely become tailwinds. New supply fell in October and is expected to remain depressed as housing market activity slows. MBS durations are now nearly fully extended. The Fed has stated it is not currently considering direct sales, and as the trajectory for rates hikes becomes more apparent, rate volatility should decline. With spreads sitting at historically high levels, we believe agency MBS issues present an attractive opportunity for high quality yield.

Securitized Credit

While the fundamentals of commercial mortgage-backed securities (CMBS) look much stronger than they did at the height of the pandemic, much of this rebound effect has run its course. While the sector is facing an acute lack of new supply, Fed policy has led to difficult refinancing conditions. That said, CMBS value remains and fundamentals continue to evolve favorably.

CLO spreads were little changed over the past month, and we’re satisfied with our outlook change from negative to positive last month. Projecting out a few months, we remain positive on the sector due to relatively attractive spreads, but over the longer term potential economic weakness remains a concern.

October technical factors led to a widening of spreads among consumer asset-backed securities (ABS), with secondary selling and new issuance trumping improved fundamentals. We expect supply to slow into the end of the year, we believe ABS will benefit from their relative merits of high quality and liquidity. Additionally, a further easing of inflation will create a positive backdrop for consumers, strengthening the entire segment. That said, the sector typically lags in volatile environments such as we saw in October.

Although home prices have declined for several months, the housing market remains on solid fundamental footing; therefore, so do non-agency RMBS. New supply has already reversed from the frenetic start to the year. We expect this trend to continue, as spreads and overall volatility should encourage mortgage loans on bank balance sheets rather than securitization. We expect rising activity and historically wide spreads to lead to outperformance into the foreseeable future.

Emerging market (EM) debt

EM spreads narrowed slightly in October, with EM corporates underperforming sovereigns. The notable exception was Chinese debt, which widened across the board. China’s Communist Party Congress shuffled leadership, focusing on security over growth, leading to a widening of spreads there. For EM more broadly, the global backdrop remains challenging, with continued inflation pressures, declining growth expectations, a stronger dollar and tightening financial conditions. Despite the headwinds, EM corporate fundamentals remain solid with healthy credit metrics.