- Performance: The expected rise in longer-maturity U.S. Treasury yields created a bear market for interest rates and led to challenging conditions across fixed income. Credit spreads remain rich by historical measures.
- Looking ahead: We'll be watching for higher, and more persistent, realized inflation—a key risk factor.
- Approach: We remain cautious and patient. Near-term opportunities exist in higher-quality financials and some select mid-quality cyclical issuers. Inflation should surge this spring and early summer. However, we don't expect this temporary surge to turn into runaway inflation over the medium term.
Patience remains the watch word
This was a broadly negative quarter for bonds, and we expect the volatility to continue. The long end of yield curves across developed markets steepened significantly this past quarter, creating a bear market for interest rates. In the U.S., the yield on the 10-year Treasury note increased more than 80 basis points over the quarter and more than 100 basis points since the first quarter of last year.
Credit spreads remain historically tight, and inflation concerns are high. Yields may still rise and curves may get steeper, but we don’t foresee a 10-year Treasury yield much above 2% in the near term, given current conditions.
It seems clear to us that this is a time for patience.
Can fixed income still play a role?
Your clients may be questioning the value of including fixed income investments in their portfolios. We disagree with those who suggest abandoning fixed income, especially in exchange for more exotic—and usually more expensive—alternatives. We believe fixed income can still provide diversification against equity risk in your clients’ portfolios.
If the roaring stock market stumbles—as it did in 2020—we expect that fixed income will prove itself again.
Implications for your clients' portfolios
Rates and inflation
Market pricing has pulled forward expectations for future rate hikes, which are running well ahead of the Federal Reserve’s forward guidance. Near the end of the quarter, the market saw the next rate hike in the fourth quarter of 2022 and as many as three hikes in 2023. By comparison, the Federal Open Market Committee (FOMC) does not anticipate raising rates before 2024.
We remain positioned for a modest move higher in yields. But after such a large move in the first quarter, we see rates more range-bound for now.
The FOMC's Summary of Economic Projections released in mid-March revised its core inflation forecast upward to just above 2% for each year through 2023. We expect the Fed to remain accommodative.
We see value in front-end breakeven inflation exposure as the fundamental backdrop remains strong and inflation risks are skewed to the upside.
Mortgage-backed securities (MBS)
Longer durations, higher interest rate volatility, and a steeper Treasury yield curve keep us less constructive on MBS broadly, and we have reduced our exposure. We believe the Fed is unlikely to withdraw its support for MBS purchases because they are a direct way for monetary policy stimulus to reach households.
The path ahead for MBS is challenging, but a bottom-up focus on security selection can add value in a more volatile market.
Credit-sector spreads traded within a tight range during the quarter, doing little to help offset the negative impact of rising interest rates. Apart from below-investment-grade corporates, which benefited from investors’ seeking refuge from rising rates, most credit sectors posted negative returns.
It's time to be restrained in credit. Spreads are compressed and the lowest-quality segments are most exposed to a shift in risk sentiment and/or a setback in the economic recovery.
It could have been a worse quarter for credit, considering that starting valuations were in the first percentile for the 10 years ended December 31, 2020, and a glut of new issuance arrived to start 2021. Still, investor cash flows into the sector soaked up supply. Improving corporate fundamentals and strong policy support for risk assets also helped.
Spreads are likely to remain range-bound in the near term. We see the best opportunities across corporate bonds in cyclically exposed BBB and BB issuers with strong fundamentals, but we expect security selection to drive performance.
CCC rated securities have outperformed their higher-quality peers for several months. Most of these new CCC rated companies are using their cash reserves due to the pandemic but are otherwise decent businesses with stronger long-term prospects than typical CCC issuers.
Nonetheless, we are cautious on high yield. The extra compensation for going down in quality in high yield is unattractive, though the recent underperformance of BBs presents some new opportunities.
Emerging markets (EM)
Both EM rates and currencies markets performed poorly in response to higher U.S. Treasury yields.
EM central banks pivoted toward tighter monetary policy, with both Brazil’s and Russia’s central banks raising interest rates as a response to high inflation. Local rates exposure could offer better value later as other central banks follow suit. That value will be realized only if real rates are positive, if rates are attractive relative to developed markets, and if local inflation comes under control.
EM bonds may face challenges over the short-term. We’ve reduced our overall EM risk across strategies, but we believe that idiosyncratic opportunities are present across the quality spectrum and that the long-term attributes of the asset class remain compelling.
A lower amount of new-issue supply and light inventory on dealer balance sheets continue to be the main story line for both asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS).
With much of the structured products market linked to the U.S. consumer, we are paying close attention to the underlying fundamentals of borrowers. The U.S. unemployment rate is roughly double what it was at this time last year. However, consumer financial health appears to be positive.
For the 10 years ended December 31, 2020, the RCA US National All Property Index increased 122%. While the COVID-19 pandemic did have a substantial negative impact on short-term cash flows for many CMBS property types, the widespread increase in property values should help borrowers as they refinance.
The American Rescue Plan Act, as well as the December 2020 COVID-19 relief bill, provide tremendous financial support to the municipal market and significantly buttress municipal creditworthiness. But the aid will also help spur an economic recovery, which can potentially create upward pressure on muni yields.
We continue to be mindful of overall interest rate risk in this environment. Since the New Year, we have modestly shortened durations across our funds while staying true to each fund’s respective mandate. This leaves us with ample dry powder to capitalize on opportunities if an outflow cycle ensues.
Credit fundamentals should continue to improve throughout 2021, bolstered by the vaccine-driven economic reopening and augmented significantly by stimulus funds. Internally, our analyst team rates every issuer we own, and we see broad-based credit strengthening ahead.
We continue to view overall credit risk as attractive. We will add to opportunities that our analysts and traders find relatively attractive, particularly in sectors tied to higher education and travel.