Fast-forward to today, however, and the backdrop for fixed income is far more encouraging. Global inflation is largely under control, while the major central banks have started their rate-cutting cycles. This includes the US Federal Reserve (Fed), which cut rates by 50 basis points (bps) in September.
Economies are cooling, but we don’t possibly expect widespread recessions. Fixed income yields are relatively high compared to recent history, providing an attractive entry point into the asset class. Therefore, we expect positive total returns, driven by the tailwind of falling rates and lower yields.
Determining the current market conditions and risks
Market conditions reflect the belief that the economy can experience a soft landing. Corporate bond spreads have tightened considerably, with investment-grade spreads below their long-term average (102 bps vs. 145 bps).1 However, all-in yields remain attractive (4.5% vs. 3.7% average).1
Resilient economic growth and robust corporate profitability have been factors driving credit spreads tighter. Corporate fundamentals remain resilient despite a marginal weakening in certain industry sectors, with leverage and interest coverage ratios at comfortable levels.
With yields in high-yield bonds north of 7%, we believe investors are adequately compensated for taking on credit risk.
Credit agencies are also forecasting a benign default environment. With yields in high-yield bonds north of 7%, we believe investors are adequately compensated for taking on credit risk, although we would caution investors to the lowest rating bands within high yield. The main risks that potentially undermine this view are a deterioration in economic growth that impacts corporate profitability or inflation pressures re-emerging, leading to central banks pausing rate cuts.
Assessing the fixed income story
The focus on outcome-oriented strategies is driving interest and asset growth. Achieving a compelling yield in a risk-controlled manner is an outcome that should resonate with many bond investors, particularly as the return on cash deposits begins to fall.
Perhaps focusing on high-quality, short-term bonds, commercial paper, and other fixed income instruments with maturities, often under one year, may help investors aim to minimize potential interest rate and credit risks. Thus, ensuring a stable return profile as a step out from cash, while still managing the drawdown experience. Finally, such a strategy can potentially provide diversification within a fixed income portfolio, balancing risk and return effectively.
Identifying the sweet spots
The first step to achieving specific investment outcomes is to identify the best type of bonds that can deliver income sources and are resilient through different market environments.
Looking back at credit markets over the long term, a strategy combining BBB, the lowest quality rating within investment grade, and BB, the highest quality rating within high-yield corporate bonds, has consistently delivered the best outcomes on a risk-adjusted basis. We believe this segment of the market is often overlooked and underappreciated by investors who focus on strategies managed against traditional credit benchmarks.
When executed within a robust framework of bottom-up credit research, it can prove to be an attractive hunting ground for delivering client outcomes.
Final thoughts
With $6–7 trillion on the sidelines, we believe fixed income offers a compelling destination for this capital. Interest rates are headed lower, which will support bond returns. Economies are slowing, but we forecast a soft landing, particularly here in the US. Lastly, we don’t expect large-scale defaults, although careful selection to avoid underperforming assets will remain crucial.
1 FRED Economic Data, October 2024.
Important information
Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
Standard & Poor’s credit ratings are expressed as letter grades that range from “AAA” to “D” to communicate the agency’s opinion of relative level of credit risk. Ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories. The investment grade category is a rating from AAA to BBB-.
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