If the big story of the moment in equities is the epic rotation out of mega-cap stocks and into smaller companies, the equivalent in fixed income is the ongoing, sharp unwind of a record-breaking US yield curve inversion.
These trends will endure for the rest of 2024, as inflation continues to decline, economic growth expectations are revised down and rate cuts become more certain.
What does that mean for our fixed income views for the next five months?
More positive on duration
First of all, it means we are becoming a little more positive on duration for the first time since the “higher-for-longer” narrative took hold at the start of the year.
Facing an inverted curve, stubborn inflation, resilient growth and increasing concern about government debt sustainability and a rising term premium, we have favoured intermediate maturities between two and seven years and remained cautious on anything longer.
That largely remains the case, but we are beginning to see more attractive value in the longer parts of that two- to seven-year range as the inflation-and-growth cycle begins to turn.
Caution on corporate credit
Second, we are more cautious on corporate credit, after taking a positive view on wider spreads at the start of the year and maintaining it through the first half.
A steepening yield curve is generally bad for credit. If it’s a ‘bear steepening’, with longer-dated rising faster than short-dated yields, it represents rising funding costs for corporates. If it’s a ‘bull steepening’, like the current one, where short-dated yields fall faster than long-dated, it represents expectations for an imminent growth slowdown.
To be clear, we are not calling for negative growth, let alone a recession. And we think relatively high all-in yields remain attractive to many investors. But a growth slowdown is likely to be enough to widen high yield spreads from what are, after all, their tightest levels in 17 years.
Those tight spreads are why we take a cautious view on credit even as small-cap stocks are soaring. While the high-yield market is priced for perfection, the past 12 months’ obsession with mega-cap tech stocks had left small-caps priced for recession.
Quality and value in securitised credit
Is there anywhere we see attractive value? Yes, and it is generally in securitised credit.
Particularly as the higher-for-longer story took hold, collateralised loan obligations (CLOs) and individual loans looked attractive for two reasons. Their floating rates offered high levels of carry income, and the senior position of loans above bonds in corporate capital structures offered a cushion in the event of any stress caused by persistent high rates – especially when combined with a bias toward higher-quality issuers.
Those higher-quality characteristics of securitised credit remain attractive as we head into a more testing economic environment.
We like agency mortgages for much the same reason, but also due to the dearth of new supply resulting from the stagnant US housing market.
But for deeper value opportunities, we increasingly like commercial mortgage-backed securities (CMBS). Here, we think that rising certainty about the downward path of rates will start to ease the fundamental pressures on real estate borrowers and reduce CMBS market volatility.
Current discounts provide a cushion against the effects of slowing growth and could start to attract value investors over the coming months, whose technical support would further reduce volatility.
Soft landing
Much of the action across markets over the past two or three weeks has been described as a soft-landing trade.
When the focus was on benign, slowing inflation, the emphasis was on the ‘softness’ of the landing – and, for example, the strong performance of small-cap stocks. As attention shifts to slowing growth, earnings disappointments and the large-caps sell-off, investors are being reminded that even a soft landing is a landing – not a take-off.
For those of us in fixed income, we think that supports a case for slightly longer duration, caution on credit risk, and a bias to high-quality securitised products and the pockets of genuine value in CMBS.
Ashok Bhatia is co-CIO of fixed income at Neuberger Berman. The views expressed above should not be taken as investment advice.