Last week, a blog post titled Fixed income investors warily eye Congress and the Fed discussed three likely government policy drivers of fixed income markets in the period ahead — US monetary policy, US fiscal policy, and the US debt ceiling. Here, we’ll take the next step of briefly highlighting some fixed income market sectors where investors might turn for attractive total return opportunities in today’s challenging environment. Indeed, it’s perhaps the most pressing question many fixed income clients have been asking lately.
A supportive US policy backdrop
The prevailing US monetary and fiscal policy backdrop continues to be broadly supportive of credit fundamentals, but many credit sectors are not currently priced for higher inflation:
- While the US Federal Reserve (Fed) looks likely to start tapering its large-scale asset purchase program before the end of 2021, the Fed of course retains flexibility to delay or slow said tapering in response to evolving inflationary and other economic conditions. In addition, Fed Chair Powell seems to have expressly “de-linked” the start of tapering from the timing of when the Fed will begin to raise interest rates.
- US fiscal policy appears to have entered an era of greater government spending, which may spur higher inflation and rising US Treasury volatility and thereby influence fixed income markets going forward. At this juncture, two potentially powerful fiscal policy tailwinds are front and center: President Biden’s US$1 trillion infrastructure plan and an even more costly budget resolution, heavy on so-called “human infrastructure,” that is working its way through Congress.
Credit spread sectors worth looking at
Against this backdrop, there are several credit spread sectors that may be worth considering in the context of an investor’s overall fixed income portfolio:
- As an income-producing inflation hedge, we believe bank loans remain attractive, both in terms of spread level and from a low risk of “loss-given-default”1 standpoint. We expect continued strong technical demand for floating-rate loan instruments at this stage of the current interest-rate cycle. Some securitized assets may also be helpful as a means of defending portfolios from the threat of higher inflation.
- One potentially elegant way to express a bullish view on bank loans is via an appropriate allocation to the collateralized loan obligation (CLO) equity sector, where we think favorable financing conditions and low projected defaults generally remain very supportive of equity holders.
- For investors who may be put off by the aggregate tightness of credit spreads these days, we believe a long/short credit strategy may be a useful tool for enhancing a fixed income portfolio’s total return but with less directional market bias.
- An allocation to convertible bonds may also make sense amid investor concerns around tight spreads, rising-rate risk, and equity markets that have recently been perched at all-time highs. The primary market here offers exposure to issuers with strong upside prospects. Convertibles also tend to have a better convexity2 profile than high yield.
- For investors interested in “risk-off” diversifiers for their portfolios heading into late 2021 and 2022, we think certain global sovereign bonds and currencies may often help meet that need just as effectively (if not more) as owning US Treasuries outright.
- Finally, we also see some attractively valued opportunities in the emerging markets (EM) debt space, where we believe investors are being better compensated for inflation risk than in the US debt market. EM local debt in particular is one of our higher-conviction investment ideas right now.
Figure 1 provides a snapshot of how various fixed income sectors may perform in different types of economic environments.
1“Loss given default” is the amount of money a bank or other financial lender stands to lose if/when a borrower defaults on a loan. | 2“Convexity” is a measure of the relationship between bond prices and bond yields that shows how a bond’s duration changes with interest-rate movements.
- Fixed income investors warily eye Congress and the Fed by Jitu Naidu and Amar Reganti (September 2021)
- Five reasons to think US inflation has staying power by Brij Khurana (September 2021)
- Are we on the cusp of an unconstrained bond fund “renaissance”? by Brij Khurana and Brian Garvey (July 2021)