2024 Fixed Income Outlook: Use Barbells to Lift Your Portfolio Weights

• Our base case is for a decelerating but resilient economy that is supportive of higher-yielding credit assets but acknowledges the low but non-zero probability of fat-tail risks. We thus favor a “barbell” approach that combines more defensive, lower-risk positions on one end while assuming calculated, much higher-yielding, higher-risk assets at the other.

• Credit appears positioned to deliver attractive coupon returns in the year ahead, but the asset class will likely face continued bouts of mini-volatility and should be complemented with safe-haven assets, including cash and government bonds.

• With leveraged finance credit yields straddling double-digits, we think they look inexpensive relative to value equities as a de-risking allocation.

• High yield bonds currently boast a combination of low prices, high yield, and moderate duration that positions the asset class for attractive total return potential, particularly on a risk-adjusted basis.

• We believe investors should not be overly concerned about defaults, which we expect to be lower than in past recessionary cycles and remain concentrated among lower-rated issuers with business model issues.

Looking to 2024, the global economic outlook appears brighter than many expected at the beginning of 2023, but signs of deceleration are emerging. We also see major variations across regions and sectors along with emerging tail risks, which will influence fixed income allocations in the year ahead.

A resilient consumer, tight labor market, and moderating inflation have bolstered macro conditions in the US, and issuer fundamentals are also in good shape despite expectations for a slowdown as the lagged effects of restrictive monetary policy take hold. Conditions outside the US look weaker, with Europe’s economic outlook deteriorating as eurozone business activity falls to its lowest level since November 2020. China remains dogged by concerns about ongoing weakness in its property sector, though the overall economy appears to be bottoming, and the rebound originally predicted for early 2023 keeps being pushed out – raising questions about a formerly reliable tailwind for global growth and markets.

But overall, developed markets are decelerating to varying degrees, and the growth differential relative to emerging markets will remain in place, albeit with a shift in growth drivers to outside of China. While central banks are not expected to turn from their aggressive tightening toward much easing in the near term, they appear to have reached their peaks for this cycle.

Here we highlight our key convictions for how global developments will drive fixed income investing in 2024.

Key Convictions

1. Fat-tail risks, while low, do bear watching – and may argue for a marginally more defensive stance.

A key trend emerging as we head into 2024 is a pickup in tail risks. In the US, these include concerns that if the Fed keeps rates up higher for longer than we think prudent, it may create an unexpected “break” in the economy or markets, and history has shown that easing cycles rarely follow a smooth downward glidepath. The US also faces the risk that a fiscal policy impasse or political gridlock will dial up uncertainty and volatility in markets. In other areas of the world, risks are emanating from the ongoing conflict between Russia and Ukraine and now Israel and Hamas. Their potential for regional spillover and unforeseen fall-on effects for risk add considerable uncertainty to the global outlook.

While we view the probability of serious “black swan” market developments as low in the short term, we’re seeing more of these tail risks starting to creep up – providing an argument for a slightly more defensive overall stance in fixed income allocations. In addition, with current higher yield curves, investors are finally being well compensated within the defensive component of their portfolios. That said, despite these and less-severe downside risks, current projections are for a deceleration rather than a classic cyclical recession in the US, with some other regions facing less positive but not dire baseline outlooks.

2. Developed market credit compares favorably to value equities.

Resilient consumer spending, a tight labor market, and moderating inflation have bolstered economic conditions in the US, and issuer fundamentals are also in good shape despite expectations for a slowdown as the lagged effects of restrictive monetary policy take hold. We continue to expect moderate default rates in 2024, near historical averages; the default tsunami that many erroneously feared at the start of the year has not materialized, and we are simply shifting from a period of ultra-low defaults to a more normalized environment. We do not view credit spread valuations as “cheap” in the context of a shift toward negative earnings trends; however, with leveraged finance credit yields straddling double-digits, we think they look inexpensive relative to value equities as a de-risking allocation. When comparing current equity risk premia and dividend ratios with credit yields (versus historical levels), leveraged finance credit looks quite compelling.

High yield bonds, for instance, currently boast a combination of low prices, high yield, and moderate duration that positions the asset class for attractive total return potential, particularly on a risk-adjusted basis. While issuer fundamentals are likely to deteriorate somewhat from current levels, earnings remain resilient, and corporate fundamentals are starting from a place of strength. The risk/reward balance for leveraged finance assets thus feels appropriate.

3. A ‘barbell’ approach may be prudent in a supportive risk environment with rising tail risks.

Our base case outlook is a decelerating but resilient economy that is supportive of higher-yielding credit assets but acknowledges the low but non-zero probability of fat tail risks – and the value of dual safe havens of cash and government bonds. Therefore, shifting toward a “barbell” approach within fixed income – one that combines more defensive, lower-risk positions on one end while assuming calculated, much higher yielding, higher-risk assets at the other – is likely to produce a superior scenario outcome than simply shifting toward a more defensive approach.

On the lower-risk portion, considering that 10-year Treasuries have moved from yielding 0.5% in 2020 to around 5% currently (in addition to high real rates) and with the tightening cycle coming to an end, government bonds are much more appealing, particularly in the belly of the curve. However, the burgeoning budget deficit and growing funding requirements will create a technical headwind, as the supply of debt is expected to keep growing.

US Treasury Yields Have Hit New Cycle Highs

Source: Bloomberg as of 30 October 2023.

At the other end of the spectrum, we view parts of the leveraged finance market as attractive, and the growth differential favoring emerging markets creates opportunities in select regional global corporates in Asia and parts of Latin America. The appeal of Asia corporates is not about a China recovery, but rather the positive fundamentals across many other Asian economies as China continues to struggle with its property sector while stabilizing overall.

Higher-Spread Segments May Offer an Attractive Risk/Reward Trade-off

Bond profiles: yields, duration, and volatility

Source: Bloomberg, JP Morgan, Pitchbook LCD as of 30 September 2023. Volatility calculated using monthly returns for the trailing 10-year time period. Treasury is the Bloomberg US Treasury Index, Investment Grade (IG) is Bloomberg US Credit Index, Agg is the Bloomberg US Aggregate Bond Index, EM Debt is JPM CEMBI Broad Diversified Index, High Yield is Bloomberg US Corporate High Yield Index, Leveraged Loans is Morningstar LSTA Leveraged Loan Index, and US CLOs is JPM CLOIE Index. Any views represent the opinion of the investment manager, are valid as of the date indicated, and are subject to change. Past performance is not indicative of future results. For illustrative purposes only.

Increasing fixed income allocations in 2024

While fixed income valuations are not particularly cheap, we nonetheless see tremendous value in fixed income today – and after a period where we had advocated for lower fixed income exposure, we now believe fixed income warrants a larger share of investors’ portfolios. For several years, fixed income often failed to deliver on its two primary objectives: appropriate yield income and downside protection. Today, we believe it offers ample amounts of both, although we think total returns will more likely approximate coupon yields over the next year.

Given current decelerating macro trends, we have a slightly more defensive bias. That said, we believe investors should not be overly concerned about defaults, which we expect to be lower than in past recessionary cycles and remain concentrated among lower-rated issuers with business model issues (rather than posing a broad-based concern).

Credit appears positioned to deliver attractive coupon returns in the year ahead, but the asset class will likely face continued bouts of mini-volatility and should be complemented with safe-haven assets. A thoughtful, active approach can help investors optimize their fixed income exposures to weather challenges and tap opportunities as the new year unfolds.

For more investing insights, access our 2024 Global Investment Outlook.