US core fixed income yields: A ray of sunshine amid economic uncertainty?

As 2023 draws to a close, we look back on another challenging year for fixed income. The Federal Reserve (Fed) stayed hawkish, yields rose broadly, and risk markets experienced bouts of volatility. While it has been a trying time for bond investors, we think the outlook going into 2024 is more positive than it has been since early 2021.

Having come through the big push up in interest rates, higher yields now offer a more attractive starting point for investors, while moderating inflation suggests the risk of further meaningful rate increases is low. Risks do remain, but we think a measured, active, and nimble approach can uncover opportunities for strong risk-adjusted returns in U.S. fixed income.

Below we highlight five key considerations for bond investors in 2024.

1. Inflation and the Fed’s hiking cycle have been key drivers of markets for the past two years and will remain front and center.

The end of the Fed’s hiking cycle is here – or at least very close – and we expect inflation to continue to moderate. The big questions are around the speed of that moderation and how much the economy and labor markets will need to weaken to achieve the Fed’s 2% inflation target. We have been encouraged – and surprised – by the continued resilience of the consumer and the economy, but we expect some softening will be required to bring inflation all the way back to 2%.

2. The full impact of previous rate hikes is yet to come.

The Fed has shown it is firmly committed to bringing inflation back to its target, and we expect its “high-for-longer” mantra and persistent policy tightening will start showing broader impacts throughout the economy. It has only been a year since the U.S. central bank instituted a more restrictive policy, with the federal funds rate first rising above 4% in the fourth quarter of 2022. Investors should expect more impacts to flow through in the quarters ahead.

In our view, the following four areas will be the most affected by the Fed’s restrictive measures:

• Consumer spending on large-ticket items (including houses and motor vehicles) is likely to soften.
• Companies will be refinancing debt at significantly higher yields. Even companies that extended prior to 2022 will face increasing interest burdens. We believe this pain will hit particularly hard in the leveraged finance market.
• Loan origination is expected to decrease across the board due to tighter lending standards at banks but will be noticeably felt in the highly leveraged commercial real estate (CRE) market.
• Government spending will be impacted as interest expense rises materially amid higher rates and a growing debt level. The interest expense on U.S. government debt is projected to surpass $800 billion in 2024 (versus $345 billion in 2020) and will soon exceed the U.S. defense budget.

The magnitude to which higher rates impact these segments of the economy will be critical to plotting the path of monetary policy, longer-term interest rates, and risk asset performance.

3. Higher yields should lead to higher returns.

If inflation continues to moderate and the economy and labor markets weaken as we anticipate, high-quality fixed income could produce strong absolute returns as it benefits from high starting yields and price appreciation from falling interest rates.

Furthermore, we see a compelling risk-return trade-off in higher-quality securities in general. In the current environment, one doesn’t need to take a lot of risk to find attractive income from bonds. With yields in the 6%-7% range across parts of the investment-grade universe, we think fixed income offers attractive risk-adjusted value relative to equities.

4. Securitized sectors are ripe with opportunity.

Securitized assets have the potential to generate better excess returns than corporate bonds of similar rating and maturity in the months ahead.

While corporate investment-grade and high-yield credit spreads are trading around their 10-year averages, securitized sectors are trading well above their averages over the last decade – a significant relative discount to corporates.

Specifically, we think commercial mortgage-backed securities (CMBS) look attractive. Concerns surrounding office real estate have led to wider spreads across all CMBS subsectors, even where fundamentals remain strong and outlooks are positive. As a result, we believe ample opportunities exist to own select CMBS assets at favorable prices.

Additionally, while exact timing is tough to predict, we expect agency mortgage-backed securities (MBS) to outperform Treasuries over the intermediate term as the headwinds that impacted MBS to a greater degree – such as supply concerns and high interest-rate volatility – begin to subside.

5. The probability of a soft landing is still in question.

While the economy has thus far proved resilient in the face of higher interest rates, the market appears to be placing a high probability on a soft landing. While the soft landing may occur – and the odds thereof have increased – in our view, the market has become too complacent regarding the range of potential economic outcomes. History has shown that it is common for the Fed to stay too tight until something breaks, and we do not believe the market is pricing in this risk appropriately.

Geopolitical risks also remain, even though their effect on markets is harder to quantify. Wars by nature are uncertain and inflationary, and conflicts in the Middle East and Europe do pose a threat to the smooth landing currently priced in. These tensions also intersect with a stressed U.S. fiscal outlook and will likely drive debate around the best path forward on government revenues and spending – policy that will undoubtedly impact financial markets and likely flow through to the real economy.

Conclusion

In our view, the current environment makes a strong case for fixed income allocations. Fixed income returns experienced stiff headwinds starting in 2021, with the abrupt rise in inflation and the Fed’s aggressive rate hikes the main culprits. We believe we’ve made it to the other side and the asset class is now at a much better starting point.

Higher rates and wider credit spreads in certain sectors have negated the need for investors to take on undue risk to reach for yield. Bonds can once again generate meaningful income and offer total return potential, while also being better positioned to provide a buffer to downside equity volatility in the event the economy weakens more than the market expects.

IMPORTANT INFORMATION

Actively managed investment portfolios are subject to the risk that the investment strategies and research process employed may fail to produce the intended results. Accordingly, a portfolio may underperform its benchmark index or other investment products with similar investment objectives.

Derivatives can be more volatile and sensitive to economic or market changes than other investments, which could result in losses exceeding the original investment and magnified by leverage.

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

High-yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.

Securitized products, such as mortgage- and asset-backed securities, are more sensitive to interest rate changes, have extension and prepayment risk, and are subject to more credit, valuation and liquidity risk than other fixed-income securities.