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Navigating fixed income as clarity meets uncertainty in the US
Client Portfolio Manager Lead for EMEA, Kareena Moledina explores how to navigate the uncertain environment through fixed income allocations, after the US Federal Reserve cuts interest rates again and Trump wins the US election.
8 Nov 2024
4 minute watch
4 minute watch
Key takeaways:
- The US Federal Reserve’s decisive move to cut interest rates again, coupled with a quick election outcome, introduces a mix of clarity and uncertainty in the US, as attention now turns towards how economic policy might look under the next administration.
- The spectre of inflation has not fully disappeared – especially given the potential inflationary pressures from pro-growth policies and tariffs under a Trump presidency.
- For fixed income investors, this means asset classes with attractive yields and spreads, such as the securitised sectors, become focal points for acting as a buffer against uncertainty and the potential for a ‘higher for longer’ interest rate environment.
Definitions
Agency mortgage-backed securities: Agency MBS are issued or guaranteed by one of three government or quasi-government agencies: Fannie Mae, Freddie Mac, and Ginnie Mae. Because of this government support, the credit risk within agency MBS is considered negligible, similar to US Treasuries.
All-in-yield: This refers to the total yield an investor expects to earn from the bond. This includes not only the interest payments (coupon yield) but also any capital gains or losses arising from changes in the bond’s price, and the reinvestment of interest payments.
Asset-backed securities: These are a subset of securitised debt, as they are bonds or notes backed by financial assets. Typically, these assets consist of receivables such as credit card payments, auto loans, student loans and mortgages.
Carry: A typical definition is the benefit or cost of holding an asset. For a bond investor this includes the interest paid on the bond together with the cost of financing the investment and potential gains or losses from currency changes.
Duration: Duration can measure how long it takes, in years, for an investor to be repaid a bond’s price by the bond’s total cash flows. Duration can also measure the sensitivity of a bond’s or fixed income portfolio’s price to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa.
Floating rate: Floating rate debt refers to a type of debt instrument whose interest rate is not fixed but adjusts at specified intervals.
High yield (HY) bond is a bond with a lower credit rating than an investment grade bond, also known as a sub-investment grade bond, or ‘junk’ bond. These bonds usually carry a higher risk of the issuer defaulting on their payments, so they are typically issued with a higher interest rate (coupon) to compensate for the additional risk.
Investment-grade (IG) bond is typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments, reflected in the higher rating given to them by credit ratings agencies.
Securitised debt: Securitised debt is a term for financial securities which are secured by contractual cash flows from assets such as mortgages, credit card receivables and auto loans.
Yield curve: A graph that plots the yields of similar quality bonds against their maturities, commonly used as an indicator of investors’ expectations about a country’s economic direction.
IMPORTANT INFORMATION
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.
JHI
JHI
View transcript
Kareena Moledina As inflation continues to fall, the US central bank has cut interest rates again, trimming the Fed rate by 25 basis points. A more reasonable pace of easing is now priced in – with markets aligned to the Fed. Compared to September, the probability of rate cuts through 2025 has decreased. Compared to September, the probability of rate cuts through 2025 has decreased.
The decisive US election brings a clarity of sorts, as we were spared a drawn out wait for the result. But the focus will rapidly shift to policy and how a Trump presidency could unfold.
The Fed was always likely to signal a return to more modest 25 basis point cuts as it seeks to balance the resilience of the US economy and its consumers alongside a labour market that is “gradually cooling” but stayed afloat.
It may be premature though to claim supremacy in the battle against inflation. There is a risk to assuming inflation is in the rear-view mirror. We believe the Fed will remain steadfast in ensuring inflation has truly collapsed.
It can always respond with further easing should we see a spike in unemployment or significant economic weakness.
The Fed may argue that it is not swayed by political interference – but any policy changes will undoubtedly impact the US economy. The Republican dominance in government could end up being inflationary.
The US fiscal deficit could balloon further with Trump’s pro-growth policies, while tariffs could escalate into a trade war creating supply shocks and temporary inflation headwinds.
Tariffs can lower consumption, but could also dampen imports – so for the domestic economy the result is not always clear. We believe bond yields should look through any tariff-related headwinds, but they could be more sensitive to concerns around fiscal unsustainability.
So how are the fixed income markets poised for such uncertainty? A favourable economic environment and company prudence justifies corporate credits spreads being tighter than historical averages. However, all-in yields are attractive relative to the past decade and could entice investors looking to beat declining rates on money market funds.
Securitised sectors, however, are often trading wide relative to history and equivalent corporate credit. When rates are falling, investors tend to seek out asset classes with higher spreads to compensate.
Right now, asset-backed securities – or ABS – is one of the few areas where both spreads and yields remain attractive. In Europe, ABS is floating rate, providing some hedge if we see the ‘higher for longer’ rate narrative transpire.
Some asset-backed securities such as autos and consumer finance are pricing in a higher probability of recession – offering extra compensation.
Agency mortgages is another sector that offers significant value. We’re seeing historically wide spreads relative to investment grade corporates and an opportunity to capture a yield advantage over Treasuries for an equivalent government-backed, AA-rated asset.
A reduction in interest rate volatility alongside central bank support for the asset class during market dislocations – as we have seen during the pandemic – are also supportive.
Looking historically at returns in the first 12 months following rate cuts, most fixed income sectors have seen positive performance. So, with the Fed easing cycle underway, it is not about whether investors hold fixed income but how much and which sectors.
As fixed income managers, relative value is a key barometer for asset allocation decisions. One way to have a buffer against a hard landing is by accessing attractive spreads – such as those found in the securitised sectors.
Another is capturing a high starting level of yields to generate income from the broad array of fixed income sectors globally.
Not taking huge bets on duration and capturing attractive risk-adjusted carry at the front end of the yield curve through floating rate debt could help navigate a ‘higher for longer’ rate environment.
We will keep monitoring the developments of monetary policy and fixed income markets to keep you connected.
Related insights
8 Nov 2024
4 minute watch
4 minute watch
Key takeaways:
- The US Federal Reserve’s decisive move to cut interest rates again, coupled with a quick election outcome, introduces a mix of clarity and uncertainty in the US, as attention now turns towards how economic policy might look under the next administration.
- The spectre of inflation has not fully disappeared – especially given the potential inflationary pressures from pro-growth policies and tariffs under a Trump presidency.
- For fixed income investors, this means asset classes with attractive yields and spreads, such as the securitised sectors, become focal points for acting as a buffer against uncertainty and the potential for a ‘higher for longer’ interest rate environment.