How To Construct A Fixed Income Portfolio For 2023
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Can you put current interest rates in perspective when it comes to the fixed income markets?
Fixed income markets in 2022 start and probably end with the Fed. So, the first thing that’s going on is the Fed has been hiking rates as aggressively as we’ve seen in about 40 years.
But that’s definitely not the whole story. Of course, there’s a yield curve. The Fed is hiking short-term rates. However, they have a balance sheet that owns about a quarter of the Treasury bond market and about a third of the agency mortgage-backed market. The Fed is also, at the same time, starting to unwind that balance sheet — quantitative tightening. That has begun. It has not thrown the yield curve into disarray yet.
We think that the Fed’s continued quantitative tightening should change some of the supply demand dynamics and may have more important impact on the yield curve going forward.
Inflation is the story driving all of this. There were a couple of benign prints for consumer price index and producer price index in early November that had the market adjusting some of its prognostications for when the Fed might stop next year. But those are not yet a trend. And so we shall see. But inflation is the story with consumer inflation running well, well above trend and Fed targets.
What about credit markets? That’s an important part of the income world. Credit markets are actually pricing in fairly healthy corporate fundamentals. In fact, corporate balance sheets are healthier than they were before Covid by some measures in terms of credit worthiness, such as leverage or interest coverage ratios actually as healthy as they’ve been in the last decade. So credit spreads for high yield or below long-term averages — credit spreads for investment greater, closer to long-term averages, credit markets telling you we’re not headed into a deep recession, in fact, it’s somewhat optimistic where, where pricing is now, particularly in high yield.
How should investors be positioning their portfolios? Are there certain segments that investors should consider allocating to?
There are many opportunities that are going to arise in fixed income markets in the next several years. But as we head into 2023, we think that there are some specific areas that investors might find most interesting and most attractive.
One sort of reflects upon the fact that the yield, or the greatest amount of yield, is in the short end of the curve. That’s because of the curve inversion, the aggressive Fed move. So there’s an ability without going out and taking on a higher duration risk to find higher yields. Also an opportunity to exploit that by investing in higher quality credit at the short end of the curve. So investment grade floating rate notes or investment grade collateralized loan obligation tranches are attractive ways of having relatively low credit risk, virtually zero duration risk, and taking advantage of high yields relative to other asset classes, even relative to some lower quality asset classes.
There is also an ability for investors who wish to take duration risk, perhaps is a bit of a hedge against, say equities, to take advantage of relatively attractive spreads and relatively sound corporate fundamentals by investing in fixed rate investment grade bonds.
What about high yield? Are there opportunities in that segment?
High yield is very attractive asset class right now, starting with its yield to worst, which is near 9%, which is actually close to very long-term historical averages, even averages before the global financial crisis, within about 50 basis points at least.
So the carry in high yield should be able to still help investors net to break even return even with about 100 and 50 basis points of spread widening, that’s attractive.
As I also mentioned earlier, fundamentals in the high yield market, much like the rest of the corporate credit markets, are better than they were in late 2019 before we headed into COVID and credit spreads are wider now than they were then. They are still substantially wider than they were at the beginning of the year.
We just think that. Should there be a harder turn in the economy, there will be more spread, volatility and perhaps some better entry levels. But again, carry is already making it a very attractive place.
There’s one final point with regard to high yield, one of our premises for investing in fixed income as we head into 2023 is playing it more up the middle, meaning, staying higher quality, not taking on excessive duration risk. Within high yield, fallen angels are an interesting category. It is a little bit longer duration now, by 1.2 years longer than broad, high yield, but still lower duration than investment grade corporate.
But it’s a mostly double B asset class, about 90% — tends to be higher quality issuers as well because they were all original issue investment grade borrowers. Fallen angels yield about 150 basis points less than broad. High yield. However, for an all, almost all double B allocation of very, very low allocation to the bottom end of the credit spectrum. Another way of sort of playing the middle, but toward the riskier side of the credit spectrum.
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All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future performance.
There are inherent risks with fixed income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. This risk is heightened with investments in longer duration fixed-income securities and during periods when prevailing interest rates are low or negative.
Investments in below-investment-grade debt securities which are usually called “high-yield” or “junk bonds,” are typically in weaker financial health and such securities can be harder to value and sell and their prices can be more volatile than more highly rated securities. While these securities generally have higher rates of interest, they also involve greater risk of default than do securities of a higher-quality rating.
A fallen angel bond is a bond that was initially given an investment-grade rating but has since been reduced to junk bond status.
Floating rate loan securities generally trade in the secondary market and may have irregular trading activity, wide bid/ask spreads and extended trade settlement periods. The value of collateral, if any, securing a floating rate loan can decline, may be insufficient to meet the issuer’s obligations in the event of non-payment of scheduled interest or principal or may be difficult to readily liquidate.
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