Between a rock and a hard place

This report was originally published on 14 June 2021.

If you feel like the current investing environment for fixed income is akin to being between a rock and a hard place, you are not alone. Not only are yield levels historically low, but it has not been a kind start of the year for high quality fixed income performance. Overzealous growth expectations in the first quarter pulled forward the first expected rate hike to the end of 2022 and an expectation that the Fed would taper by the third quarter of this year. As a result, 10-year Treasury yields reached 1.77% in March and led to poor returns for high quality fixed income segments. But the higher move in government bond yields has since moderated, as the rates market moved a bit too far too fast in 1Q21.

Since then, our short term range-bound market expectation for 10-year Treasury yields of 1.45–1.75% has held intact. And although we acknowledge the last two monthly jobs reports have been below expectations, our bearish interest rate view still holds for the end of the year. Although our view is only for a mild rise in 10-year Treasury rates to 2% by year-end, the risk to fixed income investors remains a more robust push higher, if in fact the labor market crunch proves temporary and eases after September. Moreover, now that markets have recalibrated towards the low end of the range, it enhances the risk of interest rates will move higher as second quarter economic growth peaks. The bottom line is that the recent trend of a rising equity market, combined with declining Treasury yields, is not likely to persist as the economy recovers.

However, rising rates will not be the Achilles’ heel that derails the current recovery or credit risk assets if it is accompanied by growth, particularly if financial conditions remain accommodative. Although we anticipate the Fed to announce tapering over the next few months, we do not feel this will have a material impact on credit spreads. This is supported by the Fed’s recent announcement to begin unwinding its pandemic-era investment grade (IG) and high yield (HY) corporate bond and ETF purchases, which only resulted in IG spreads moving a mere 1bps on the news.

Reaching late-cycle spreads with a midcycle recovery

We are currently witnessing late-cycle credit spreads, while the economic recovery is entering an early/midcycle phase. The Fed’s quantitative easing program has lent a helping hand. One of its main goals is to encourage the flow of credit to the economy by forcing investors out of safer bonds into riskier ones. With the Fed taking high-quality bonds out of the market by buying AAA quality Treasuries and agency MBS, investors are forced to move down the credit curve.

The amount of monetary and fiscal accommodation entered in the marketplace quickly propelled spread compression to historically tight levels. But when we look at positive fundamental indicators such as declining default expectations and upgrade-to-downgrade ratios, we believe these compressed spread levels can remain in this range for the second half of the year, and likely some time beyond. Although we anticipate the Fed to announce tapering over the next few months, we do not feel this will have a material impact on spreads.

With that said, a range-bound spread environment is not immune to pockets of vulnerability. We just don’t believe they will be sustained, and we continue to view the potential headwinds to total returns as a rise in interest rates, with little protection on the downside in terms of spreads.

We have not changed our recommended fixed income allocation given our outlook of stronger growth and a gradual rise in interest rates. Although both senior loans and HY spreads remain at the tighter end of the range—445bps and 330bps, respectively—fundamental conditions support staying long credit, and these tighter spreads could remain in this range for an extended period. We foresee limited total returns in high grade assets such as Treasury and IG corporates. Our preferred allocations remain within senior loans and CMBS.

Interested in our fixed income views in more detail? Take a look at our latest Fixed Income Strategist report titled "Between a rock and a hard place."

Contribution from Leslie Falconio, Senior Fixed Income Strategist Americas

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