2024 Midyear Fixed Income Outlook: Keep the Barbells, But Diversify Your Weights

• Our key view for the remainder of 2024 is that investors should not assume a hyper-defensive stance, despite the seemingly high valuations: rather, they should maintain the barbelled approach we had advocated to start the year but with an increased focus on diversifying risks at one end while looking beyond cash at the other. Such diversification extends to potential geographic benefits in assets like emerging market corporate credit, rather than an argument for excess yield pickup.

• Looking at specific areas of opportunity, leveraged loan yields are still in the 9%-10% range, which is attractive on a risk-adjusted basis, with superior relative value in the B-flat and B+ rating segments. In CLOs, given tighter valuations and risks that are tilted to the downside, we favor positioning higher in the capital stack overall and taking advantage of new issue yield premiums to secondary spreads.

• In high yield, while the CCC-and-below segment shows elevated spreads, many issuers are facing idiosyncratic issues, and we believe now is not the time to overweight that segment. From a geographic standpoint, Asia’s high yield market continues to offer an attractive spread advantage despite some compression.

• For investment grade, longer-end credit spreads are trading at ultra-tight levels, whereas intermediate credit still offers reasonable compensation, in our view.

• Mortgage-backed securities (MBS) remain cheap versus corporates on a relative basis, but the technical factors behind this outcome are not necessarily going to reverse in the near term.

At the midpoint of 2024, fixed income investors are still in an environment of elevated policy rates, with expectations having shifted toward modest Fed cuts later in the year and a global easing pathway commencing at a much slower pace. Entering the year we favored a barbell approach to fixed income that combined more defensive, lower-risk T-Bill positions on one end while assuming calculated, much higher-yielding, higher-risk assets at the other. This tactic has worked well thus far – particularly the lowest-risk cash component at the defensive end, and higher-risk leveraged loans and Asia high yield at the other. Floating-rate credit has been among the best-performing fixed income asset classes so far this year, with leveraged loans (Morningstar LSTA index) turning in a return of more than 4% through May as compared with negative returns for much of the core fixed income universe.

Floating-Rate Returns Have Outpaced Those for Other Core Assets

Source: Bloomberg, JP Morgan, and Morningstar as of 31 May 2024. Returns proxied by Bloomberg US Agg Bond TR USD; Bloomberg US Credit TR USD; Bloomberg US Corporate High Yield TR USD; Bloomberg US Treasury Bills TR USD; J.P. Morgan CLO TR USD; and Morningstar LSTA US LL TR USD.

Looking toward the second half, we believe that at the index level, most fixed income risk asset classes are trading through fair value to varying degrees – a critical investment challenge that argues for a bottom-up approach that considers specific subsegments or individual issuers’ attractions or risks. A handful of areas are screening cheap on a relative basis, such as agency mortgage-backed securities (MBS). But with limited opportunities for spread compression and price appreciation, targeting assets that are poised to return currently elevated yield income should produce an attractive outcome.

With the base rate component now providing an outsized component of yields, total returns – including for credit assets – are poised to be driven primarily by shifts in the yield curve. Therefore, we think it is also prudent to maintain a more barbelled approach to rate positioning while adding to our initial duration underweights toward a more neutral stance.

Our key view for the remainder of 2024 is that investors should not assume a hyper-defensive stance despite the seemingly high valuations; rather, they should maintain the barbelled approach we had advocated to start the year but with an increased focus on diversifying risks at one end while looking beyond cash at the other. Such diversification extends to potential geographic benefits in assets like emerging market (EM) corporate credit, rather than an argument for excess yield pickup.

Keep the barbell, shift the hedges and risks

To start the year, we had been much more conservative than the broader market on the likely pace and extent of Fed rate cuts, but we are now in line with revised market expectations of only one to two cuts for the year. There is an increasing discussion of a “no cut” scenario, even among some Fed members. While that probability has risen, we think it’s unlikely and still expect the initial cut to commence in late summer.

US Policy Rates Remain Elevated, and Expectations for Cuts Have Moderated

Source: Federal Reserve Bank of St. Louis as of 31 May 2024.

Notably, irrespective of when and how the Fed moves, we think it’s an attractive time to add some additional exposure at the back end of the yield curve. While we do not expect back-end yields to decline sharply in the near term, overall yields are attractive while potentially providing a hedge against risk in the event of an unforeseen market shock.

To that end, within the defensive element of fixed income portfolios, where we previously favored primarily cash with small allocations to longer-dated Treasuries, we now prefer a more balanced barbell approach. Because the rate-cutting cycle appears likely to be slow and gradual, the roll-down effect of cash and the negative yield curve should still be effective within fixed income portfolios, while the longer end should help protect against an unexpectedly sharp downturn in the economy.

At the spread end of the quality barbell, we view geographic diversification as especially valuable among risk allocations. A US-based developed market investor, for instance, could consider an allocation to European debt (with a more supportive ECB versus the Fed) or look even more broadly to areas of emerging market debt (with more favorable relative growth trends). We see attractive opportunities in emerging market corporates, and particularly in areas of the Asia fixed income markets, as a means of diversifying risk.

We have favored floating-rate credit asset classes (bank loans and CLO debt tranches) relative to fixed-rate asset classes (such as high yield bonds), but while spread differentials still support bank loans over high yield, we believe those trends will largely equalize over the remainder of the year. This is particularly due to the difference in convexity of floating-rate credit, which primarily trades with negative convexity due to above-par price levels, whereas fixed-rate credit offers positive convexity.

Among the less-liquid assets, given the strength in broadly syndicated loans, we’re seeing that broad swaths of private credit in particular are taking on more risk to compete while being paid less to do so. This dynamic is quite evident in the upper middle market, where the majority of private credit now operates, as their AUM base has grown too large to operate in the smaller lower middle market. The upper end competes more directly with broadly syndicated loans, while lower middle market private credit has been less affected.

Key investor takeaways

We believe now is not the time to try to outperform by taking highly concentrated risks – given current valuations, we think investors are not being compensated sufficiently to do so, even in a benign market risk environment. Again, we believe the key will be in not going hyper-defensive but in truly diversifying risk.

We’re currently finding relative value in the following areas and segments:

• Leveraged loan yields are still in the 9%-10% range, which is attractive on a risk-adjusted basis, with superior relative value in the B-flat and B+ rating segments.

• In CLOs, given tighter valuations and risks that are tilted to the downside, we favor positioning higher in the capital stack overall and taking advantage of new-issue yield premiums to secondary spreads.

• In high yield, while the CCC-and-below segment shows elevated spreads, many issuers are facing idiosyncratic issues, and we believe now is not the time to overweight that segment. From a geographic standpoint, Asia’s high yield market continues to offer an attractive spread advantage despite some compression.

• For investment grade, longer-end credit spreads are trading at ultra-tight levels, whereas intermediate credit still offers reasonable compensation, in our view.

• Mortgage-backed securities (MBS) remain cheap versus corporates on a relative basis, but the technical factors behind this outcome are not necessarily going to reverse in the near term.

While we see relative value in the areas above, we believe most fixed income risk assets offer limited excess return opportunities, despite attractive yields. For this reason, we encourage a focus on careful bottom-up issuer selection and risk management to opportunistically tap into the most compelling assets as they emerge in the second half.