Fixed Income Outlook: Finally, a flattener
In this era of unprecedented financial repression, a steepening bias has been a relatively easy call for our fixed-income team to make. After all, cash rates have held at or near 0% for more than five years, and rates in the intermediate 2- to 5-year range have hovered around historical lows. Despite the efforts of the Federal Reserve—or perhaps because of its efforts—the longer end of the yield curve has experienced the biggest move up over the past year. Hence, we have favored a strategy that has underweighted longer Treasuries.
Now, however, we are making a change. With the pending demise of quantitative easing and the rough timetable established for tightening beginning to come into view, we think the biggest moves up in rates this year likely will occur along the belly of the yield curve—specifically, in intermediate-maturity issues. As such, we are shifting our recommended bond portfolio model from a modest steepening to a modest flattening bias that utilizes a barbell approach, i.e., the movement of money out of the belly to the extreme ends of the curve.
This shift, frankly, is aimed more at losing less than it is at earning more from government bonds. The reality is the rising-rate environment that is expected over the course of the year—driven by the Fed’s pullback and a likely economic rebound as winter’s icy grip passes—will undermine values across the Treasury curve. This is why we also are limiting rate exposure by keeping duration at 85%, well short of neutral.
Not much to like about Treasuries beyond TIPS
It helps that our overall exposure to Treasuries in our bond model remains at a significant underweight, a stance we have held for some time. It should be noted, however, that this does not include Treasury inflation-protected securities (TIPS). We are neutral to slightly constructive on TIPS, which look somewhat cheap and can act as a nice hedge against inflation, which if the recent bump up in wages holds, could potentially surprise to the upside. Higher inflation would benefit TIPS relative to nominal Treasuries, and higher inflation is one of the goals Fed policymakers have set.
Corporate bonds relatively attractive
We also think the best opportunities in fixed-income are where they have been for the better part of the past five years: credit. We continue to like corporate bonds, both high-yield and investment-grade, just not as much. Our overweight position in both has been lightened. High-yield and investment-grade corporates should continue to benefit from sluggish economic growth, robust earnings and healthy corporate balance sheets. But spreads—the gap between yields with comparable maturity Treasuries—already are trading below their historical medians on high yield, meaning there’s not a lot more value left in this trade. Investment-grade corporate spreads also are trading at to slightly below historical medians.
EM reverts back to slight overweight
We moved from a modest overweight to neutral on emerging-market (EM) debt early this year as jitters in countries such as Turkey, Argentina, South Africa and China spawned a sell-off that caused spreads to widen, undoing much of the narrowing that occurred last fall. Now, with several EM countries having addressed their fiscal and economic issues and Chinese authorities signaling a willingness to prevent growth from slipping below 7%, it appears spreads are ready to narrow again, prompting us to reverse our call back to a slight overweight. After depreciating significantly, currencies in several EM countries also appear poised to appreciate, further creating potential value.
In sum, opportunities in the fixed-income world have shrunk from a relative and absolute perspective on prospects for stronger domestic growth and higher interest rates. But strategies that favor credit and are prepared for a flatter yield curve should still help the long-term, diversified investor capitalize on the potential opportunities that are available.