Fixed Income Outlook: A one-size-fits-all strategy may no longer work
Even with historic Fed easing, the fixed-income investment process over the past five years has tended to follow predictable risk-on or risk-off themes. When strengthening economic fundamentals looked to lift growth and nudge interest rates higher, you’d pull in duration and add to spread product. When growth appeared ready to weaken or events such as the Japanese tsunami or euro crisis spooked the markets, you would push out duration and move to high-quality Treasuries. We wouldn’t say it was easy to make money — timing, as usual, was everything when it came to allocating dollars. But the broader risk-on or risk-off strategy worked pretty well.
Not now. The fixed-income market is caught in various cross-currents. While key sectors of the economy — housing, autos, manufacturing, employment, consumer spending — appear to be improving, taking recession risk off the table, there is still a good deal of uncertainty about the economy, with a global overhang that has yet to be resolved. Moreover, the half-loaf solution to the fiscal cliff has only pushed the big showdown over the debt ceiling and entitlements down the road a few months, meaning policy uncertainty also remains very much a part of the environment. And wrapped all around this is the reality that spread has tightened significantly across the board, making valuations relatively rich and absolute gains harder to come by.
We have to earn our money
The last two months were instructive. The very low-to-no risk end of the risk spectrum, i.e., Treasuries, had modest positive returns, while the highest end of the risk spectrum, i.e., high yield and emerging market, had relatively large positive returns. But the middle of the risk spectrum, i.e., investment-grade corporates, had marginal negative returns. There may not be a one-size-fits-all strategy anymore — we’re going to have to earn our money. This is why, at least in the short run, we’ve taken almost a bottom-up view of things. We are dissecting each sector based on its own fundamentals and technicals, and then focusing on security selection within those sectors with which we find favor. That’s a different point of emphasis for us, and that’s leading to some conclusions that might seem a little bit mixed.
Underweight investment grade, overweight TIPS
For example, we are now slightly underweighting high-quality spread product, specifically investment-grade corporates, where spreads — yields relative to comparable Treasuries — have tightened below historical means, which suggests there’s little upside and a much less favorable risk-return payoff. At the same time, we believe there is still value in Treasury Inflation-Protected Securities (TIPS), even though they’ve had a nice run and look relatively expensive. This is because among the many things it is telling us, the Fed says it will allow its inflation band to creep up, centering around 2% but allowing up to 2.5%. We’re taking policymakers at face value, and believe based on past history that there’s a material chance they may miss to upside. This would benefit TIPS, where current breakeven spreads in the 2% to 2.5% range are below the likely Fed outcome.
High yield, emerging market and commercial MBS
As for the more aggressive spread sectors, we’d rather take risks in areas where we still are getting paid even if it’s less than we were getting paid before. High-yield and emerging-market bonds continue to offer potential returns well above investment-grade bonds, with higher absolute yields — thus more income and spread opportunity — and less sensitivity to domestic interest rates and policy. As long as the U.S. and emerging-market economies continue to grow and companies continue to generate robust profits even with the lack of significant top-line growth, these sectors remain attractive. We also have shifted to an overweight in commercial mortgage-backed securities (MBS) on the general improvement in real estate and the quality of the deals we are seeing. If we don’t get a recession and have enough positive job growth, a lot of the underlying collateral in office buildings should be able to maintain valuations.
It's going to come down to February
We gradually moved duration to a more neutral stance, stuck between a potential flight-to-quality that a Fiscal Cliff Round 2 could bring and economic fundamentals and Fed statements that suggest potential stronger growth and higher inflation in the second half. Longer-term, we look to be defensive, but with yields on 10-year Treasuries having jumped 50 basis points off their lows to around 1.90%, we don’t believe now’s the time to make a dramatic move — particularly in light of what could happen in Congress next month, as the talks to address the pending debt-ceiling breach go full bore. We think the Republicans are going to dig in on spending cuts, even though they probably won't get as much as they want.
It’s not clear what the markets want, either, but a new International Monetary Fund study that came out this month offers some grist for the mill. It was a mea culpa, of sorts. It admitted that the severe austerity measures forced upon Greece and other peripheral debt-laden eurozone countries hurt their economies a lot more than the IMF and other policymakers thought they would. That has to give pause to those of us in the fiscal-discipline camp, aka, the bond vigilantes. Perhaps the best we can hope for from Congress and the White House is a realistic plan the country can stick to over a long period of time. There are no quick fixes to this. You can’t unwind a decade of deficit growth in one year. It’s all about changing the direction of spending, setting the inflection point to begin to trend down, not up. That, we believe, would be welcomed by the markets.