Global Perspectives: Opportunities in fixed income as the Fed approaches its terminal rate

Lara Castleton: Hello and thank you for joining this episode of Global Perspectives, a Janus Henderson podcast created to share insights from our investment professionals and the implications that they have for investors. I’m your host for the day, Lara Castleton, U.S. Head of Portfolio Construction and Strategy, and today we’re digging into all things fixed income with Seth Meyer and John Lloyd. Seth and John are portfolio managers on several fixed income strategies at the firm, including both being on the multi-sector credit strategy. Gentlemen, thank you for being here. You look wonderful.

Seth Meyer: Thanks for having us.

John Lloyd: Thanks for having us.

Castleton: So, the beginning of the year we were talking about bonds are back. And Seth, I think you were actually demanding Backstreet Boys as your walk-up song any time you entered into a room. That’s been the message broadly this entire year. The income is finally back in fixed income. We know, however, I want to dig into that, because fixed income isn’t a uniform investment. There’s lots of ways to access the bond market.

And so, for listeners here today, let’s just get a little bit more specific in terms of what we mean by bonds being back. First, Seth, I want to get to you and just talk about a quick fixed income health check-up. So, after the great reset of rates in 2022, what’s the environment been like this year in fixed income?

Meyer: So, largely in 2023, the great rate reset that we all experienced and saw in 2022 has largely continued, obviously depending on geographic location or how aggressive a central bank has been. But for the most part, depending on where you’re looking on the US curve, we continue to move with rates higher. Anywhere between 30 or 50 basis points we’ve seen rates increase.

And why is that? The markets continue to wrestle with the same themes we’re dealing with, with 2022, to a lesser extent. We’re not going to move from a 1% rate up to a 4% rate. Now we’re talking incrementally. Are we going to end at 4.5%, are we going to end at 5% in the ten-year I’m speaking, or is the Fed funds going to terminate it at 5.5%? But the themes have been largely the same.

Inflation is starting to roll. That’s been very, very clear. Economies are slowing. I think the surprise in 2023, relative to what we would’ve thought at the start of the year, has been the relative strength. I don’t think most were expecting most economies to power through a very aggressive Fed rate hiking cycle the way we have.

And then, thirdly, how the central banks, regardless of whatever central bank you’re talking about, is going to deal with that sort of equation, raising rates, squashing inflation, without impairing growth. That’s why we continue to see this repricing of risk. It’s been interesting, though, when you have had rates move as high as we have, we still are talking about core plus bond funds with positive total returns, and the reason is because of your starting yield.

That’s why we were bullish when we started in January with bonds, and the cushion that you inherently have today relative to where we started in 2022. As a matter of fact, the more down in quality you go, the higher your return so far has been. So, best performing asset classes have really been below investment-grade corporate credit. You’re talking about mid-single-digit yields, and that’s because of where we started from.

So, nothing has really changed. We’re closer to the end than we were in January. The market continues to price an aggressive Fed, and if you look at six-month forward expectations in January, we’re 50 basis points higher than what we thought we would be when we started the year today. But I think we all kind of come to some conclusion that the Fed is closer to the end than they were six months ago. So, with that, with where yields are, we still believe that fixed income is very attractive, and the total return outlook looks pretty favorable.

Castleton: Okay, so, 2023 has still been driven by a lot of the same risk, mainly in interest rate risk dominating, but we’re coming to an end. You got into this a little bit, but John, just more specifically, what actually has worked a little bit better than other areas of the market in fixed income this year?

Lloyd: Yes, I think one of the biggest surprises we’ve seen is the spread markets, and Seth touched upon this with the low investment grade has worked really well. So, high yield has tightening in to almost 100 basis points from the start of the year. Now, we had some volatility with the banking crisis in between on that. But I think the answer of why that happened is, we went through one of the most aggressive Fed tightening cycles we’ve been through.

And at one point, almost every economist on the street had some type of recession forecasted into the future, the near-term future. And we may be at a point now where Powell has a higher chance of a soft landing, where we don’t hit a recession. The GDP numbers have been really strong, third quarter estimates continue to be strong, as well, and on the other side, you’re seeing core CPI inflation starting to roll down. So, we may get this perfect balance of the Fed tightening enough where they’re bringing the CPI and inflation levels down, and it’s not hurting growth as badly as investors thought.

So, that’s been really good for high yield. It’s been really good for securitized credit, especially below investment grade, this year. And what hasn’t it been as good for? We still have rate volatility. I think, as Seth highlighted, we’re at the end of that cycle. It’s hard to say, are we finished at 5.5, could we still get one more hike this year? We could. But you’re very near the end, and we’re starting to see interest rate volatility come down.

But because it’s been volatile throughout the year and rates have increased, mortgage spread are wider, and obviously anything with duration, interest rate duration, hasn’t been as good a performance as credit spreads.

Castleton: Okay, so, the below-investment-grade universe has worked out a little bit more this year, however, as we’re coming to the end of the rate-hiking cycle. We’re feeling a little bit more opportunistic on just more duration-sensitive assets. So, broadly speaking, it seems like we’re still bullish on fixed income, so we have to talk about the big theme that we’re hearing from pretty much every client.

Money markets are giving you 5%, and that is a pretty compelling number, and an asset that’s pretty sure for most investors psychologically. So, I want to go back to you, John, just risk and reward of 5% money markets.

Lloyd: Yes, I think money markets was really, really attractive as you’re going through a Fed rate-raising cycle, because you don’t exactly know when they’re going to stop. You don’t know how fast CPI is going to cool off, and you don’t know if they’re going to damage the economy. So, it’s a safe place to hide. Now that we’re at the end of that, and we can see what it’s doing to the economy, and we’re generally, I’d say, at the end of where rates should level off, there’s a lot of benefit to owning duration and adding yield above money markets.

So, what are those? Well, first, the correlation between rates and spreads should revert back to what it was. I think that’s been one of the toughest things for fixed income investors, is, as rates rise, spreads have sold off over the last two years. There’s no balance there. If the equity market sells off because rates rise, you’re not getting that protection in a 60/40 balance-type portfolio, either, right? Our expectation is, that should revert now. And duration, if we do go into any economic downturn or softness, duration should provide a cushioning benefit or volatility dampener in that type of market.

Secondly, I think it’s our view that rates will be higher for longer, but they’re not going to be here forever. I don’t think we’re in a major regime change where the long-term inflation rate is going to be 3%. So, as that migrates down to 2%, we should see rates normalize over time, and that’s beneficial for the fixed income market, as well.

And then, you’re also getting, in certain parts of the market, you’re getting a lot of excess spread for taking credit risk right now. There’s still a fair amount of fear out there that we won’t hit a soft landing. And I think in some markets, spreads are even pricing in, even if we go into any type of mild recession, you’re getting a lot of excess spread.

So, that’s another reason to move out and take a little more yield than just your traditional money market account. Because if you think about fixed income, usually your yield to worst is the return you’re going to get a year forward. And so, in high yield right now, you’re in 8.5%. In securitized credit, you’re even higher than that. That’s a good forward indicator of what returns can be in the future.

Castleton: And does this story apply globally, as well? So, also, obviously, our listeners are global, but Europe is a little weaker, it seems, other areas of the region. Is it still a similar story in terms of markets coming to the end of a rate-hiking cycle opportunistic to add in to duration in most economies?

Meyer: I think the interesting part about as we move forward, is central bank policy by region will start to vary. So, we haven’t seen, it’s almost been lock in step. Everyone is fighting the same fight right now with inflation. It is clear there are certain regions of the world that are ahead of this game, and certain regions of the world that are behind. And that policy decision-making processes will be dictated on, one, where they are in the cycle.

So, if you do look at Europe, bringing that up just as an example, it’s clearly behind the U.S. in their inflation fight. So, it does seem that the ECB may remain hawkish longer than the U.S. Fed will be. The most important part as we look forward is how quickly central banks adjust to what John was talking about. Is it higher for longer? Probably. But who does blink first on the way down?

So, we’ll start to see disparity in policy, which, when you think from a global investor’s perspective, taking advantage of some of these front-end yields, because they won’t last forever, and extending a little duration is probably a pretty good recipe for thinking about total returns. When you start having disparity, it’s going to create the opportunity, and I think investors will be able to generate some significant total returns in fixed.

Castleton: And the other thing that I hear is, generally most investors are comfortable understanding that they’ll get that total return balance once the Fed, or whatever central bank, does start to cut. What about just when they pause? Is there value to just starting to leap into these duration assets just as we’re ending? Is there a perfect time to get into duration?

Meyer: Historically, and looking at history is all we have, is to say, when the Fed has been doing this, so then you get to this point, what happens after? So, six rate-hiking cycles, if we look at the last six, when short-term rates peaked, you were better off going long duration at that point than staying in cash. Five out of six of those instances. And then the one instance that was even close, returns were really close to each other.

Now, the problem with that analysis is typically the Fed oversteps, and the Fed has to correct, and that does create this opportunity of total return. I think it’s an interesting way to think about protection for a portfolio. If your return’s at worst cases, we look forward, are close to flat where you are at cash. But they stub their toe, we stumble economically, the Fed has to get more aggressive in cutting, you have that protection in order to offset some of the volatility you might be seeing elsewhere in your portfolio. That’s the way we’re thinking about it.

t’s not about saying we’re really, really bullish duration here. It’s about saying, all right, now let’s get back into what John was saying. Correlations are going to start going back to the way they were historically. And when that happens and we do economically stumble, you’re going to want more duration in your portfolio. So, you’ve got to be thinking about doing that well ahead of time.

And now, because we’re cresting, at least the theme, if you can’t pick up on it between John and I, it feels like the front-end rates are getting to the point that we’re starting to peak. If that’s the case, you’re going to want to be thinking about duration.

Lloyd: I would also add to that, too. With real rates at the ten-year spot above 2%, that’s pretty high. And so, I would imagine, over time, those would come down, and that’s the benefit of owning long duration. Just if the economy even hums along, you don’t really need a 2, 2.5% real rate range. That should be much lower over time.

Castleton: Yes, that’s super helpful. I know it’s very uncomfortable leaving the sure thing today for something that is a little bit more uncertain, but everything that you both discussed should hopefully give investors that confidence to start to edge out, take that leap, and go into duration.

But of duration, John, again, this is back to thing, we like bonds, we like duration, but it’s not all created equal. So, when you’re getting down into sectors, you teased this out a little bit at the beginning, maybe, mentioning some securitized, butwhat should investors be thinking in terms of sector implementation?

Lloyd: Yes, I think one of the interesting things in the market right now is valuation dispersions across sectors. High yield in investment-grade corporates right now are inside the 50^th percentile. They’re pricing in a pretty high probability of a soft landing or a very moderate recession. I think valuations are still compelling, but they’re not screaming cheap at this point.

You move over to the securitized space, and that’s where things are screaming cheap. You can start with highest-quality assets in securitized which is agency mortgages, and they’re trading at the cheapest levels they’ve traded versus investment-grade corporates since the GFC.

And people ask, well, why is that? One, they don’t love interest rate volatility. Two, we had some bank failures with the FDIC assuming those portfolios and selling off those mortgage loans, as well, which created a huge supply technical in the market. So, that’s created what we believe is a huge opportunity in the agency mortgage market. And that’s reverberated through the entire securitized credit market, so you look at ABS and CMBS for different reasons, but basically those markets are pricing in, if you go to the valuation side, they’re pricing in a recession still.

And they’re near wides, if you look back at recessionary times, whether than was 15 with the energy crisis, oil crisis, December of 18, when you had the Fed raising cycle, or even the GFC, they’re almost at or past through those levels right now. So, to us, that creates a lot of opportunity for investing in those sectors.

Castleton: And so, securitized assets, which is generally more difficult to do, that market’s a little bit more complicated, access to that we’re seeing broadly being a little more attractive as an entry point because of that spread being a little wider. But one concern I do hear, Seth, is CMBS. So, you mentioned that, John. That is in the headlines of commercial real estate quite frequently. There’s a lot of doomsday predictions around that sector. Can you just address those? Do you agree? Or what might people be getting wrong with that sector?

Meyer: I think whenever you have the fastest rate-hiking cycle in recent memory, recent history, it’s going to create some opportunity. And I think CRE, CMBS, office, Class B, Class C malls, all of these, thrown them in a basket of struggling assets. Why? It’s a direct reflection of, right, these assets need leverage in order to survive. That’s actually how you purchase them. You talk about LTVs between 45 and 70%. When rates are going higher, it makes it significantly more challenging to refinance.

So, that’s the obvious. That’s the if-nothing-happened problem with real estate. Now, we know something has happened. Class B, Class C malls, we all go home and there’s 17 boxes on your front porch delivered from Amazon from a distribution warehouse that wasn’t located there five years ago and now is a brand-new, beautiful building.

That structurally changed the way Americans consume and purchase and move forward as we go through with our lives, and really made the need for a Class B, Class C mall just non-existent. That permanent change and structural change to the way we think about retailing in this world.

Now, think about with office. So, what has happened? Well, the work from home phenomenon, COVID, and the lack of urgency of going back to the office or need, really, to go back to the office, has created what we’re seeing, which is some of these buildings empty, occupancy rates hitting all-time highs in certain markets, and there’s no doubt about that.

When you think about the bifurcation, though, of what is actually happening in the broader CMBS market, this ignores themes that are actually benefiting from this. So, distribution warehouse is one. I mentioned that a second ago. When you think about that from the perspective of leisure or hospitality, hotels, you can play in the CMBS space in hotels, and we’re seeing all-time high RevPAR, which is revenue per available room. All-time high margins, the benefit of vacationing we’re seeing in this country.

Or data center warehousing. I know one thing for sure, is AI will consume more data. When we need to consume more data, I would assume there would be more data warehousing needs. So, there’s also tangents within CMBS to say we can really exploit these themes that we like. Cash flow is growing, asset is still there, we feel comfortable owning it.

There are troubles. You think business or office spaces in malls. With office space, just in general terms, central business district office space will be under pressure for years. I can’t see a way out of it. That doesn’t mean your local office space for a lawyer or a doctor or physical therapist is going to be stressed, but certainly central business district.

So, how this plays out over the next few years will be really key. We are really focusing on a couple of things. One is location. When we think about investing in this sector, it’s all about where you’re located. You can’t recreate a downtown LEED-certified building in San Francisco. It is located in that spot. It is prime real estate. Even with the issues we have in San Francisco, when office does return, they will steal share.

So, it’s identifying these marquee assets, whether it be that building in San Francisco, that hotel in San Diego, that casino in Las Vegas, and really exploiting the themes that we’re seeing. Because what we have seen now in the past six, seven months is just a repricing in aggregate of the assets, almost indiscriminately, regardless of whether you are an office building or you’re a casino in Las Vegas. That’s what makes us excited.

We do think the theme of getting involved in office is still a little too early, but we’ve seen this play out before. Downtowns come back, they figure out their way through these, and they will. Location, location, location. It does demand capital at some point.

Lloyd: The other theme I would add to that, too, is, even within office, we really like life science. It’s something you can’t work from home, if you’re doing lab work for Pfizer. They sign a 25-year lease, they put a huge amount of tenant improvements into the building, and they haven’t figured out how to let their employees do the lab work from home. So, that’s a great area of the market where you’re seeing wider valuations, because people have allocated away from CMBS based on the fears of Downtown San Francisco.

Castleton: It’s just important to be picky. So, thank you both for that. To summarize, makes sense to start to add in duration, makes sense to be very specific on sectors. We’re really favoring often a lot of the securitized market over certain areas of the credit market.

But let’s just get into, then, the implementation of these ideas for our investors. So, you mentioned at the beginning, I think it was you, Seth, just the importance of the starting yield today. So, if we’re thinking about capitalizing on these opportunities, venturing outside of money markets, which are 5%, that raises the bar. Can you just talk about a little more that importance of that starting yield to be a consideration?

Meyer: I think John mentioned it earlier in the podcast. There’s very few things that are such a strong predictor of your forward total returns in the starting yield to worst the day you bought a bond. And it’s a very powerful thing, because there is a component of the yield you’re clipping, but also the dollar discount you’re buying.

So, if you buy a bond right at 90 cents on the dollar, and it’s going to mature in five years at par, and you underwrote it correctly, meaning it’s not going to file for bankruptcy, you’ve just locked yourself in two points a year, effectively, because you need to eventually get to that par number. That doesn’t even include the yield that you’re clipping along the way.

So, the power right now in today’s fixed income market relative to three, four, five years ago is the percentage of the market that is actually trading below par. That’s a really powerful thing from an investor’s perspective. Your bonds are accreting up each year that goes by, because that bond will have to mature at par, unless there’s a default.

When I think about the yield to worst is a really good starting, like here’s my flag in the ground expectation as to what to think about from a return perspective, but the real power to it us how many bonds you’re getting that are under par within that portfolio, which is really the juice from an investor’s perspective to help protect in returns as we look forward.

Castleton: Thank you. And John, what’s the benefit, then? So, starting yield’s so important. What’s the benefit of going into someone active, truly active in this market, versus, say, sometimes coming across just passive allocations, benchmark of an Agg in the US, as an example? Is there a benefit to really going active in this space today?

Lloyd: I think this is one of the best times in my career to be active, because we’re seeing so much dispersion across asset classes and within asset classes. And so, you can go underwrite bonds, like Seth talking about, that are well under par. Trading in the high-yield market, the average dollar price has been hovering in the high 80s. So, there are a lot of great companies you can go out there and underwrite, and underwrite for alpha at this point, if you’re an active manager.

We talked about the sector dislocations. CMBS has pretty massive dislocations right now, where you can get outsized returns for taking actually on growth investments. That’s pretty rare in the marketplace. And then just your sector allocation, as well, for strategies that dynamically asset allocate across sectors, there’s a lot of alpha to be had right now, choosing the right sectors that are cheap.

Castleton: Well, in multi-sector credit strategies in that category in general, it does have an additional level of flexibility, too, over just the intermediate space. And that maybe provides some opportunity in addition today, given the yield in the below-investment-grade space. Would you agree?

Lloyd:  I totally agree. Like I said, at times, in securitized, you don’t have to go down below investment grade. You can just go down to the BBB space, and you can get spreads that are in line with the high yield market today. So, you’re looking at investments that are high yield-like in return potential, but are investment grade. And like I said, then you can also make that sector allocation, and pick the best sectors, and over-allocate to them, where a passive fund doesn’t do that at all.

Castleton: Right, okay. And then, Seth, would you say anything in terms of the category in general, multi-sector, you get a lot more variety in outcomes from manager to manager. Anything that you would have investors be keen on in terms of picking the right implementation there?

Meyer: I think within the category itself, it’s important to identify those true multi-sector portfolios. What we’ve come across and what we’ve seen, even within our competitive set, are portfolios that stay in one asset class. In order to be truly multi-sector, you need to have multiple levels of expertise, and even more importantly, multiple levels and levers to pull to generate alpha. That means going outside of one asset class and looking for the opportunities, really, where they lie.

I think about even the CMBS question you were asking earlier, being able to identify that individual property in order to actually generate alpha for investors is key, I think, as we look forward, rather than buying a collection of assets. Investors get themselves into trouble thinking that way.

By buying ten Class B and Class C malls, you didn’t diversify yourself. You actually doubled down on an exposure. Now, yes, regionally you did. You owned one in Omaha, and one in Des Moines, and one in Philadelphia, but you’re still attached to the same tenants.

Now, if you can dig in and find that one asset that’s going to be just fine through this economic environment, that’s where the bottom-up fundamental work that you do, that you look for in an active manager, really pays off.

Castleton: So many things to consider, but thank you both for all those insights. I think that really helps paint a picture on the opportunity in fixed income, but help answer the question of what fixed income do we go into. So, thank you both, and thank you for our listeners for tuning into this episode of Global Perspectives. If you’re interested in more insights from Janus Henderson, feel free to download other episodes of the podcast wherever you get them, or visit our website at janushenderson.com. I’m Lara Castleton. See you next time.