Fixed Income Asset Allocation Insights: Finishing Strong at the Midyear Mark

Most risk assets generated strong returns into the end of the second quarter alongside significant improvement in investor sentiment. From an excess return perspective, mortgage-backed securities (MBS) turned positive following the historical wides relative to credit seen earlier in the quarter. Emerging market (EM) debt also continued its positive momentum into June, with excess returns turning positive year-to-date. After mixed performance earlier in the year, all fixed income asset classes are now positive on an excess return basis year-to-date.

The improvement in risk markets came despite a more hawkish than expected narrative from the Federal Reserve in June. Even with a pause in interest rate hikes at their June meeting, FOMC participants broadly anticipate future interest rate increases, with the median interest rate dot for 2023 revised higher to show two more hikes this year. In contrast to the Fed, the European Central Bank continued to raise interest rates through their June meeting, with ECB President Lagarde indicating they are not considering a pause, despite inflation cooling at a faster-than-expected pace. Looking forward, while there is still much uncertainty in central bank policy, the pace of interest rate increases has clearly declined, and in US the end of increases appears in sight.

Following the recent rally, valuations appear fair to tight given the economic backdrop. Labor markets and consumer spending remain strong despite persistent inflation. While there have been improvements in inflation data, the speed to normalization remains a key question. The fundamental backdrop also remains solid, albeit weakening, as issuers are set up well for a slowdown. However, we expect the economy and corporate profits to slow as the lagged impact of restrictive monetary policy takes hold.

As we move into the second half of the year, we remain constructive yet cautious against a backdrop of slowing growth, expected bouts of volatility, and uncertain central bank policy. Higher yields have attracted investors globally and should temper any potential selloff, with many potential buyers waiting in the wings. We favor a nimble approach given the uncertain path, leaving us the ability to react quickly to both risk-on and risk-off shifts in sentiment.

Our Asset Class Outlooks

Click each asset class to learn more about the fundamentals, valuations, and technicals driving our outlook.Investment Grade Credit We expect credit spreads to remain largely rangebound as we approach the end of the Fed’s rate hike cycle. We remain of the view that the economy will experience a slowdown that will more firmly reveal itself in the second half of the year as the lagged effect of policy actions and their outcomes take hold. We expect more volatility in credit spreads and interest rates, but both are likely to be relatively muted compared to what we have seen over the last several months. We believe there will be attractive entry points in the next several months, creating additional opportunities to add risk.Securitized Products MBS spreads blowing out to 190 basis points (bps) marked a capitulation moment, and buyers rushed back in even with FDIC sales looming (spread data from Bloomberg as of 26 June 2023). We are also starting to see signs that banks have slowed down their reductions in MBS holdings. As a result, we are constructive on the asset class. Meanwhile, within commercial mortgage-backed securities (CMBS), it’s too early to call whether fears have been totally baked into pricing. A higher-for-longer Fed stance would reduce hopes that lower rates will help maturing loans with refinance risk.Leveraged Finance The issuer base is set up well for a slowdown, and future default rates are largely accounted for at current spread levels. Total returns look attractive at current spread and yield levels given our moderate default forecast. We favor positioning higher in the capital structure when available and are less constructive on lower-quality credits.Emerging Markets Disinflation trends in EM have broadened and strengthened over the past month, and the market is bringing forward rate cuts. Also, EM growth continues to surprise to the upside and outpace developed markets, despite weakness in China. From a risk-adjusted return perspective, corporate investment grade (IG) screens as more attractive. Sovereign IG has also improved on a relative basis in the context of Fed pausing, lower volatility, and duration extension.Non-US-Dollar Currency The Fed is getting closer to peak policy rates, and the current pause may extend longer than anticipated, eroding the broader support for the US dollar. As US exceptionalism is expected to fade over the next 12 months, and most long-term valuation models suggest the US dollar is overvalued, we expect the weakening US dollar trend to persist.

Segment Snapshots

Using our independent analysis and research, organized by our fundamentals, valuations, and technicals framework, we take the pulse of each segment of the global fixed income market.

Investment Grade Credit

US Dollar Investment Grade Credit

Dana Burns, Portfolio Manager, US Dollar Investment Grade Fixed Income

Fundamentals Fundamentals remain strong, although we’ve seen some notable downward revisions on expected second-quarter earnings and a softening outlook in general. We view the current regional bank stress as contained, with credits trading more on fundamentals.

Valuations After the recent tightening in spreads, the broad market looks slightly less attractive. However, appetite for the robust new-issue market, and the long end in particular, points to select pockets of value.

Technicals The technical backdrop has softened, with decreased foreign demand due to higher hedging costs. However, less-than-anticipated supply along with the approach of the usually quiet summer period should support markets. Tighter supply and fewer bonds available for sale have supported long-end spreads.

Non-US-Dollar Investment Grade Credit

Roberto Coronado, Portfolio Manager, Non-US-Dollar Investment Grade Credit

Fundamentals Neutral. Companies in general continue to beat expectations, while net leverage is slightly below 2020 levels – thus balance sheets remain in good shape. We will monitor how inflation impacts the bottom line.

Valuations Neutral. We see credit spreads close to fair value and expect the index to trade within a range in the coming weeks. In our opinion, the probability of large index moves is low in either direction. For that reason, we believe sector and security selection will be key to outperformance.

Technicals Neutral to positive. Inflows have been small but positive in recent weeks, while primary supply has slowed over the past month. We expect supply to be very low during the summer, helping the technical picture in the near term.

Securitized Products

Andrew Budres, Portfolio Manager, Securitized Products

Fundamentals Interest rate volatility has finally started to come down and has dragged mortgage-backed securities (MBS) spreads down (tighter) with it. However, the relationship between the two is still relatively wide.

Valuations The widening of spreads to 190 in May marked a capitulation moment and showed that there is a cap on how wide spreads can go, which was encouraging given the difficult technical environment for MBS of late. (Spread data from Bloomberg as of 26 June 2023.)

Technicals While technicals are a headwind in the MBS sector right now, the disposition of the FDIC portfolio has proceeded much more positively than investors had expected two months ago.

Leveraged Finance

John Yovanovic, CFA, Head of High Yield Portfolio Management 

Fundamentals Last-12-month (LTM) par default rates are now at 2.4% (or 1.5% excluding distressed exchanges), well off the lows from a year ago but still below long-term historical averages (according to JP Morgan data as of 1 June 2023). We see default rates peaking in the 3.5% area, although there is clearly a risk that this will be more of a plateau than a peak. Upgrade/downgrade ratios remained balanced in May, as rising stars are making up for downgrades among struggling credits.

Valuations The market has moved materially tighter as the end of earnings season left a news vacuum, with the B and CCC tiers tightening the most. We still see 400-600 as an appropriate option-adjusted spread (OAS) range given our default expectations (i.e., that they won’t exceed historical averages but could stay elevated for longer), and we believe volatility will persist given the likely slowing of the economy, which should manifest itself in earnings dispersion.

Technicals May new issuance totaled $29 billion, the strongest month since January 2022, with almost all deals rated Ba/B. Refinancings remain the largest use-of-proceeds category, loan refinancings are outpacing bond refis, and merger and acquisition (M&A) activity remains low. Fund flows have been mixed, with a fair amount of back-and-forth from week to week. (Technicals based on Bank of America data as of 2 June 2023.)

Emerging Markets

Sovereigns

Anders Faergemann, Portfolio Manager, Emerging Markets Fixed Income

Fundamentals We remain constructive on the fundamental outlook. Reform momentum has picked up in the last month (in Nigeria, Turkey, etc.), and economic activity overall has held up better than expected, with growth in emerging markets (EM) outpacing developed market (DM) growth. We still see Asia as the best-performing region this year, despite getting off to a slow start due to China’s more gradual recovery. Strong disinflation trends in EM should lead to sizable rate cuts in the second half, which also bodes well for EM assets into 2024. The market continues to focus on debt repayments two to three years ahead, with many of the weaker credits pricing in a too-high probability of default.

Valuations The Fed pause and a sideways move in US Treasury yields during the last month caused an increase in risk appetite, which has driven high yield (HY) spreads much tighter and in line with our fair-value estimates. Investment grade (IG) spreads narrowed by 10 basis points (bps), versus the 90-bp tightening in HY. The EMBI Index is back to its early-March spread level of 444. Another 40 to 60 bps of compression may follow if the Fed starts communicating rate cuts. But for the time being, valuations are screening unfavorably. (Source: JP Morgan as of 23 June 2023.)

Technicals Redemption and coupon flows are expected to rise swiftly in July. This, in addition to slower outflows out of hard currency funds and a rise in inflows into local currency funds, paint an improving technical picture. We still expect HC flows to turn positive with the US dollar on a weaker footing and the Fed rate cycle at a peak. Net issuance is still expected to be negative for the year.

Corporates

Kim Keong, Trader, Emerging Markets Fixed Income

Fundamentals We saw limited changes to credit trends over the past month, so have maintained a neutral stance given the distribution across both IG and HY. This is also in line with expectations that leverage will stay around current levels this year, based on relatively flat EBITDA overall (albeit with regional differences depending on commodity exposure), coupled with limited debt moves given low-single-digit capex growth.

Valuations Over the past month, CEMBI BD spread to worst tightened 35 bps, with HY (-66 bps) outperforming IG (-15 bps). The tightening in IG spanned regions but was more pronounced in BBBs (-20 bps). Within HY, LatAm (-63 bps) and Asia (-83 bps) outperformed CEMEA (-55 bps), although Turkey (-123 bps to date in June) is the main driver this month after retracing following the election. EM corporates have outperformed DM over the last month: IG outperformed US IG by 5 bps over the last month, and HY outperformed by 25 bps. However, over the past three months, EM HY has lagged by 65 bps and 60 bps YTD. Our IG stance is back to neutral given that spreads have returned to the historical range. (Valuations and technicals, below, based on JP Morgan data for the CEMBI Broad Diversified Index as of 14 June 2023.)

Technicals Month-to-date supply of $11.4 billion versus the monthly average of $41 billion and scheduled monthly cash flows of $21 billion indicate another month of negative net financing. YTD supply of $120 billion is down 23% year over year, and J.P. Morgan recently downgraded its full-year supply forecast by $51 billion to $253 billion on lower supply expected from Asia and LatAm. Net financing is expected to be -$121 billion (versus -$84 billion year-to-date). We believe the technical picture remains strong given the limited expected issuance and scheduled cash inflows, particularly on the IG side. However, our HY stance is neutral given the weaker demand technicals affecting liquidity and price action in the short term.

Non-US-Dollar Currency

Dmitri Savin, Portfolio Manager, Portfolio and Risk Strategist, Emerging Markets Fixed Income

Fundamentals Policy rate and growth differentials remain the key currency drivers for the medium term. While we have scaled back optimism that the European Central Bank can go it alone in tightening monetary policy, forward-looking indicators suggest the ECB will stay hawkish for a little longer than the Fed.

Valuations Ultimately, the shrinking policy-rate differential should support a stronger euro, though not to the extent we had expected even a month ago, with eurozone growth waning more quickly than previously anticipated. We maintain our 12-month EUR/USD at 1.125 and our 12-month forecast for USD/JPY at 132.5.

Technicals According to JP Morgan and IMM data as of 18 June 2023, US dollar positioning is now 0.6 standard deviations below five-year averages, cutting net shorts by 57% after four consecutive weeks of deleveraging. Meanwhile, positioning deteriorated for European currencies as European net length declined ahead of central bank meetings.