The macro story
The macroeconomic backdrop today — inflation, the path of interest rates, the labor market and the health of the U.S. economy — continues to loom large for fixed-income investors, even as they are seeing a higher level of yields across the credit spectrum. As institutional investors re-assess their fixed-income allocations with an eye toward improving their long-term risk-adjusted profile, they need to carefully consider the impact of restrictive monetary policy on economic growth, both in the U.S. and globally.
“We believe we’re at a point where we’re starting to see the impacts of restrictive monetary policy weigh on the economy and impact the consumer,” said Margaret Steinbach, fixed-income investment director at Capital Group. “That’s what happens when the central bank raises interest rates by over 5% in 18 months’ time.”
Since March 2022, the Federal Reserve has raised rates 11 times, pushing its key interest rate to a target range of 5.25% to 5.5% — the highest level in more than 20 years. The central bank moved quickly to drive down 40-year-high inflation, which peaked in June last year when the consumer price index reached 9.1%. Now the Fed appears ready to keep its foot on the gas, with inflation still above its 2% goal, even as evidence is building that it has moderated while the employment market remains resilient.
A downward trend
While fixed-income asset managers are optimistic, they caution that we may be near the top of the rate cycle, so investors should watch for unexpected surprises and a potential growth slowdown.
“We’ve seen inflation moving sharply lower, along with sustained favorable employment statistics,” said Matt Steinaway, senior managing director and chief investment officer of global fixed income, currency and cash at State Street Global Advisors. “The Fed, to this point, has demonstrated the ability to pull off a historically significant pace of rate hikes while maintaining the balance within the labor market.” He expects inflation will continue to trend lower, with core inflation reaching the Fed’s target in 2024, which will, in turn, lead the Fed to lower rates.
“We do see the core [price index for personal consumption expenditures] inflation trajectory taking us to the 2% target rate in 2024, if not through it, which, in our view, will lead to the Fed reducing rates in 2024,” he said. The labor market is likely to soften through the back half of the year, giving the Fed room to put the brakes on its tightening policy, but there will be continued debate among central bankers over the pace of inflation, said Steve Boothe, head of global investment grade at T. Rowe Price.
But “where this view might be challenged is around the pace of the disinflationary trend,” he said. “I think it’s too slow for comfort for a handful of members of the Fed. That said, I suspect when you combine labor market softness with a clear trend of lower inflation, that creates conditions for the Fed to pause.”
Capital Group’s Steinbach pointed to the decline in core inflation, which doesn’t include food and energy costs. “We are seeing inflationary pressures moderating, and that’s pretty consistent across the board,” she said. “Most, if not all, of the ‘sticky’ measures of inflation have turned.” Less than a year ago, 80% of the components that make up the core consumer price index were rising at an annual rate of more than 4%. “Today that figure is 50%, and the other inflation components are declining,” she said. One key indicator she’s watching is the real estate rental market, given the sizeable weight of shelter prices in the CPI basket.
“Our expectations are that inflation continues moving in this direction, but stickiness in some components may prevent it from reaching the Fed’s [2%] target this year,” Steinbach added. “But easing to 3% or 3.5% by year-end, or early next year, is certainly going to put less pressure on the Fed to keep raising rates.”
The Fed could eventually do what Steinbach called a “maintenance cut” if the inflation trajectory declines along the path she expects, yet it would first need to see “conviction that inflation is moving downward sustainably,” she said. “The last thing that [Fed Chairman] Jerome Powell wants to do is ease too soon and see inflation reaccelerate. For now, the Fed remains really cautious regarding the tightness of the labor market.” The Fed would need to see labor market normalization before introducing a maintenance interest rate cut that would bring policy rates more in line with the inflationary dynamics, she explained.
Clearly, there’s still uncertainty about whether the economy is out of the woods from the unprecedented pace of Fed rate hikes. Even with declining inflation and the steady labor market, a recession remains a distinct possibility. Fixed-income investors and asset managers are interpreting the recessionary tea leaves in different ways, but in all cases, they emphasize the need for prudent risk assessment in light of the uncertainties around the pace and scale of a growth slowdown.
Steinaway pegged the probability of the U.S. economy slipping into a recession at about 30%. “We’re still concerned about the risk that the Fed either continues to raise rates in response to persistent inflation levels or that the economic drag from past rate hikes will impact employment, overall economic activity and, ultimately, lead to a recession,” he said. “We are starting to see some softening in real wage growth. We’ve seen our own internal metrics around economic activity weaken, so we’re still wary of the recession possibility.”
David Gaito, head of direct lending at Fidelity Investments, is less sanguine. “In the last 18 months, the market’s perspective has shifted from ‘low rates, inflation is transitory in a risk-on environment’ to ‘5%-plus [secured overnight financing rate]; and inflation’s not transitory, it’s high and sticky,’” he said. “As the Fed puts the brakes on the economy, it’s hard for me to comprehend a soft landing.”
Another key indicator is the decline in consumer savings. “The consumer has driven the economy pretty far, but at some point the consumer has to run out of gas,” Gaito cautioned.
“I’m hard pressed to believe that we land the plane softly and just keep going,” Gaito added. “The markets feel hot again. I’m looking at these factors and trying to understand what will go wrong if the economy enters a recession, because I’m just skeptical of going from zero to 5.5%” interest rates without economic consequences.
Broad opportunity set
Despite nagging uncertainty around just how the Fed’s interest-rate hiking cycle will affect the economy — and the possibility that rates will need to stay higher for longer due to persistent inflation — fixed-income investors are seeing the highest yields in a decade. With yields relatively high, including high-quality assets, investors are assessing compelling opportunities across the fixed-income and credit spectrum, even with a defensive posture.
Boothe at T. Rowe Price said he believes policy uncertainty is lower today than at the beginning of the year. “We are closer to the end of the hiking cycle, so that pulls a degree of policy uncertainty out of the market. We also have a higher degree of certainty around what the balance sheet will look like going forward,” he said. “I’m not suggesting that risks are nonexistent, but a few of the debates that we were having last December and January are known knowns at this point.”
And although those “known knowns” have been priced into the market, Boothe said he favors a defensive approach to credit. “At current valuations, the margin for safety is thin, so I do think defensive positioning is appropriate,” Boothe said. “To be fair, this view appears to be reflected in investors’ positioning. And there is a risk-light positioning that contributes to a risk-asset performance tailwind as we make our way into 2024,” he added.
That said, the fixed-income market has ample opportunity. “For a yield-oriented buyer, the opportunity set is much larger today relative to 10 or 15 years ago. This is a function of higher all-in yields across asset classes,” Boothe said. “Specific components of the bond market offer what would have historically been equity-like returns. Another example of the expanded opportunity [that higher] yields present is if you have an 8% nominal return bogey, high-quality investment-grade credit looks appealing and can contribute to return objectives.”
While interest rate volatility has been high, Capital Group’s Steinbach said she expects it to decline “in the not-too-distant future” as the Fed winds down its hiking cycle. “Lower volatility combined with a higher-yield environment is a good backdrop for allocating back into fixed-income markets, whether you are an investor who has [either] a more sanguine or more pessimistic outlook on the near-term macro backdrop,” she said.
The question is where to allocate: short, intermediate or long? The answer depends on the investor, their goals and their expectations. Asset managers look at different considerations on duration, depending on investors’ risk-reward objectives.
“We do think the rest of 2023 to 2024 will be volatile across the curve, but we think these are pretty compelling entry levels in the intermediate space for U.S. rates,” said State Street’s Steinaway. “We tend to prefer opportunities in the intermediate part of the curve. The front end will remain volatile as the market positions around news flow and shifting Fed expectations, while the long end presents challenges in this rate environment. Our current bias remains toward that intermediate bucket from a portfolio construction perspective.”
Capital Group expects the yield curve to steepen, which leads to a focus on the front end, the two- to five-year maturity range, and underweighting long-term maturities, or 10- to 30-year securities. “That [yield curve] position is really a risk-reward exercise,” Steinbach explained. “If you look at where valuations are today, with the yield curve extremely inverted as a result of the Fed having hiked rates over 500 basis points, that’s a great entry point for what we call yield-curve steepeners, which is a position that would, in particular, protect our portfolios in a risk-off scenario.”
“We’re somewhat defensively positioned, but more so taking a balanced approach to allocating risk across interest rates and credit markets,” she said. “This defensive positioning for a steeper yield curve offers attractive risk-reward in terms of where we think the yield curve can go from here. This is balanced by a selective approach in credit markets.”
T. Rowe Price’s Boothe is also focused on the short end of the curve. “I think there is an opportunity here for yields to move lower across the curve. Where we have a little more conviction is the front end of the curve,” he said. “We think there are pockets of opportunity in the front end, particularly around the two-year, if you can stomach the volatility,” he said.
“We also think the curve is just too flat. So our view has a bit of a steepening bias. There’s a path over the next two to three quarters where conditions start to surface where the yield curve should come off of this deep inversion and steepen to some extent.”
Across the pond
Looking outside the U.S., the European Central Bank has largely been on a rate-hike track similar to the Fed’s, but economies across Europe have not been as resilient as the U.S. and are facing higher recession risks — in some cases, much higher. Nevertheless, global fixed income also presents selective opportunity today.
“When you consider Europe, these economies continue to have more structural challenges — including labor markets — than the U.S.,” said Steinaway at State Street. “The current market environment, where there has been a rapid increase in global rates, has had an adverse impact on these economies, including high inflation and now, slowing growth. As a result of these structural issues and the current environment, these markets are fundamentally in a much different and more negative position than the U.S. markets,” he said. “This doesn’t mean there aren’t positive returns available in European fixed income, but you have to be much more opportunistic in terms of risk appetite.”
Capital Group’s Steinbach pointed to emerging markets, especially in Latin America, where central banks moved early and aggressively to raise interest rates, leading to some compelling yields. “A lot of economies, particularly in Latin America, experienced inflation earlier than developed market economies, [and] those central bankers were aggressive in hiking rates early,” she said. “We’re looking at attractive real yields, and those investments could be further supported by any continued decline in the dollar.”
Private credit beckons
Attractive yields in the private credit markets have drawn asset allocators, though they remain cautious about tightening credit spreads and rich valuations in some segments. While market fundamentals today are sound — corporate balance sheets are strong, for example — they could deteriorate quickly in a recession.
“Credit spreads are tight in both investment grade and high yield, and they appear rich to us,” said Steinaway at State Street. “The demand side of the valuation, away from historical spread levels and fundamentals, appears to be weaker going forward based on economic concerns. Higher yields help but don’t fully offset these other factors in the overall portfolio construction.”
At Capital Group, portfolio managers are balancing more defensive interest rate positioning with selective opportunities in the credit markets. “Securitized credit, in particular, is one area where we’re seeing quite a bit of value,” said Steinbach. “There’s been significant spread widening as a result of all of the concerns around commercial mortgage-backed securities and office space. That’s resulted in the whole sector moving wider in terms of spreads. So we’re seeing a lot of value in certain parts of the CMBS market, particularly single-asset, single-borrower deals, like single-family rentals and industrial warehouse-type exposure. Security selection will be critical as investors continue to contend with market uncertainty.”
“It’s a broad statement but given how institutional investors are generally positioned overweight to risk assets, there’s been quite a bit of investment in private markets and private credit,” Steinbach added. “Today’s macro backdrop and starting yields are attractive for adding some high-quality exposure back into portfolios.”
Activity in private credit has been picking up, said Boothe at T. Rowe Price. “That’s an area that investors haven’t focused on enough over the last 10 years,” he said. “The way we’re thinking about it regarding institutional investors is, depending on your objectives, depending on what your return hurdles are, there’s a lot more opportunity that maybe you haven’t thought about over the last 10 or so years.”
Active with passive
Passive allocations have become important complements to active strategies in fixed-income investing, particularly as advancements in fixed-income trading, reporting and transparency have driven innovation in passive strategies.
One common approach is to use passive strategies for a core fixed-income allocation along with active strategies for satellite or more specific, targeted allocations. Another approach is to use indexes for particular factor or risk exposures.
State Street’s Steinaway said the fixed-income market is following the path of the equity market 20 years ago, with greater transparency, more liquid trading and more data. These help investors get comfortable with the idea of passive indexing, including “the outcomes they get from indexing as well as the role that indexing can play in a broader portfolio,” he said.
“It’s not a substitute, but rather a complement to active, and a low-cost way to access the core exposures,” Steinaway said. “That core-satellite argument has taken hold in fixed income and investors are increasingly comfortable using indexed fixed income as a core exposure.”
The distinction between using passive products in an active strategy and indexing is a critical one in the fixed-income market, according to Boothe at T. Rowe Price, who estimated passive strategies account for about 35% of the market. “There’s a lot of room in participants’ portfolios for index products,” he said. “Having low-cost access to very particular betas or factor exposures on an index basis, even as an active manager, I can acknowledge that that is an appropriate component of a broader asset allocation.”
He reiterated, however, that where indexing can be valuable is in creating specific factor or risk exposures that complement the core allocation. “When I think about the future of indexation and innovation around that,” Boothe said, “it’s about introducing a particular factor or risk exposure to a broader allocation.”
“These are active portfolios, engaging with the market on a regular basis to rebalance and put flows to work. And as they grow in size and market share, the influence on market behavior and impact on price can be meaningful,” he explained.
“That said, the idea of creating a particular factor exposure or particular risk exposures that clients want replicated is important. The idea of factor investing is popular in the equity market, and you’re going to see more and more of this concept take hold in bond markets,” said Boothe.
One risk of passive, or indexed, investing in the bond market is that investors may not be paying attention to what’s in the fund, Boothe said. For instance, concentration and duration risk may be overlooked. When interest rates spiked over the last 12 to 18 months, passive fixed-income investors were likely to be surprised by the duration of their index funds, which led to disappointing returns. In addition, unlike in the equity market, the average core bond manager typically outperforms the index.
Read: Fund Finance: Why now?
Private finance takes center stage
Over the past decade institutional investors have allocated funds to private credit strategies, such as direct lending and credit financing, as they’ve pursued diversification and yield, but recently interest in these strategies has accelerated. Pensions & Investments' 2023 report on the 1,000 largest retirement funds said that their allocations to private credit reached $98 billion in the year ended Sept. 30, 2022, up from $87.1 billion in 2021. Private credit overall had reached a record $1.5 trillion in assets under management globally as of September last year, up from $626.2 billion five years earlier.
The growth of private credit as an industry can be pegged to growing demand from private equity managers to fund deals. Historically, such funding came mainly from banks, but as regulations tightened after the Global Financial Crisis and bank balance sheets became stressed, that source of funding dried up. The regional banking crisis earlier this year has kept up the pressure on sources of funding, providing asset managers the opportunity to step in — a trend that is likely to continue.
“In the early days, 20 to 30 years ago, funding was provided by banks, commercial-finance businesses, insurance companies,” said Gaito at Fidelity. “What’s happened post-GFC is that the delivery of middle-market credit has largely moved to direct lenders. And comfort with this strategy has only grown.”
With the shrinking of bank financing, direct lending has accelerated the growth of private credit strategies, he noted. “That’s only gotten stronger. The demand drivers, the end users of this product, are largely private equity. In addition, in the middle market, where private equity is paired with private credit, there’s still a major gap in dry powder between the two asset classes, which suggests another strong tailwind for direct lenders.”
Shelley Morrison, head of fund finance at abrdn, said the long-term growth in private markets, the GFC, the pandemic and credit market volatility last year have all contributed to the pullback in bank financing. That has opened up considerable opportunity for institutional investors to participate in fund financing — loans provided to private market funds, including private equity, credit, infrastructure or real estate across various stages of their lifecycle.
Private credit strategies enable investors to diversify a portfolio away from risk assets like equities and provide attractive risk-adjusted return potential. In addition, they are stable and have low risk of loss.
“Alternatives in general help you expand your investment universe. And they have the potential to help enhance returns and income, and are generally a diversifier to your portfolio,” Gaito said. “Direct lending can provide you real return in most environments because it’s got a floating rate. So as inflation rises and rates follow, your return goes up with it. And when inflation is very low, and the credit market pricing is very low, you still have a meaningful spread above the public markets,” he said.
Institutional investors are stepping into the void left by traditional bank lending by providing two types of funding: subscription line credit facilities, also known as capital call lines, and asset-backed fund finance, Morrison said. abrdn specializes in subscription line credit, and its proven resilience through the GFC and the pandemic has made the asset class “really attractive to the institutional market.”
Not only is the supply side of private credit favorable, demand from borrowers is high as well. “The borrowers are the private equity funds or the private credit funds that are using credit facilities to bridge the acquisition of assets in their portfolio,” she said.
Subscription financing offers similar benefits to private credit, Morrison said. “It’s a stable asset class, with low levels of volatility and low levels of correlation to other asset classes, particularly public equities and public credit,” she said. “We’ve had a couple of great case studies in the asset class: the Global Financial Crisis and COVID pandemic, and also some of the volatility in the credit markets last year. Those case studies have shown subscription lines to be very resilient and robust. It’s an asset class that performs well during good market conditions and during the challenging parts of the credit cycle too.”
Subscription financing can also diversify a private credit allocation, enhancing a portfolio’s overall fixed-income sleeve. “When we speak to clients, they are typically looking to diversify their private credit portfolios. They’re looking for something that they don’t already have,” Morrison said. “They’re looking for something that isn’t traditional direct lending, that isn’t real estate loans nor high yield. Subscription financing is something new that has low levels of correlation that really help them to build diversification into their credit portfolio.”
Additional benefits of subscription financing are low credit-loss risk and solid return potential. “The asset class has a zero percent loss rate for credit risk,” Morrison added. “The final big draw for institutional investors is strong risk-adjusted returns and a healthy illiquidity premium. Specifically, we’re talking about investment-grade-quality floating-rate assets that are short tenor, so there’s close to zero duration.”
Both subscription financing and direct lending offer an illiquidity premium, which helps keep volatility low. Direct lending has low volatility because it’s not an asset that trades frequently, and investors need to keep that consideration in mind, said Gaito at Fidelity.
Understand the nuances
In the current environment — a relatively strong economic picture that’s showing signs of slowdown after aggressive rate hikes — finding opportunities in direct lending has become more challenging, but they are out there.
“High free cash flow businesses with a moat and a durable history of performance are what we look for,” Gaito said, adding that Fidelity’s team also looks at underappreciated sectors that other investors may avoid.
“If everyone else is avoiding something, there also could be opportunity,” he said. For example, many of the businesses in health-care services that were financed around 2021 are “stressed due to high amounts of leverage,” Gaito said, but Fidelity’s team has found significant opportunities in the current vintage. Another sector of interest where they invested last year was logistics, where several firms had benefited from the pandemic-related supply-chain issues. “While many were cautious in this space,” Gaito added, “my team utilized our experience and research to invest in companies that we felt could withstand a downturn.”
“There are always places where you can make good investments, but you have to know what you’re good at. You have to know what your strengths are,” he said.
At abrdn, Morrison said finding investment opportunities and getting the structure right requires a deep understanding of the market — from borrowers to lenders to regulations in different jurisdictions — and investors’ objectives. It’s about “understanding the various market players and their investment strategies, their silos and making sure that it’s mostly compatible with delivering the highest returns,” she explained. Also, as fund financing requires a very specialist form of due diligence and underwriting, the abrdn team ensures that the legal structuring and due diligence is robust and watertight on their transactions, she said.
Morrison also pointed out that fund finance is not a one-size-fits all solution. “There’s a lot of opportunity for different tenors, different geographies, different investment strategies,” she said. “It is overwhelmingly an investment-quality market, so within that, there are very different types of risks. It’s a great asset class for investors that want to get a little bit creative and structure something bespoke to their requirements.”
Gaito said he expects there could be bumps in the sector in the near term due to higher interest rates and inflation, but he added: “I believe the long-term outlook is strong for private credit. If you’re [allocated] with the right manager, that manager should deliver the benefits of direct lending, which is (real) equity-like returns with low volatility.”
Morrison said three major markets — the U.S., Europe and Asia — all face varying levels of uncertainty on the macroeconomic front and their fund financing sectors are behaving differently. But the supply-demand balance for private credit in all three regions still favors investors.
“Supply-demand imbalances remain strongest in the U.S. for fund finance,” she said. “It’s really healthy that we’re beginning to see institutional investors interested and active in closing the funding gap. That’s great for borrowers and lenders. When you see choice, you get innovation. And that’s certainly what we’re seeing now with investment structures and credit facility structures.”
“Long term, we’re feeling positive; some of the unsettled times that we’re seeing right now will be positive long term for this asset class,” Morrison said.
Seizing the moment
Historically, institutional investors have been underallocated to fixed income largely because they were unable to meet their return targets. Pensions & Investments' data on the top 1,000 pension plans found that fixed-income allocations of the top 200 defined benefit plans largely declined for the past five years. In 2017, their average allocation to U.S. fixed income was 22.6%. By 2021, that had inched up to 22.8%, but in 2022 it slipped to 21%. Corporate defined benefit plans had a more robust allocation to U.S. fixed income, 44.2% in the year ended Sept. 30, 2022, while their public counterparts had allocated 19.3% of their portfolios to U.S. fixed income.
With rates back up and yields at attractive levels, today could be the time to rethink those allocations. In the public markets, “this is an opportunity that we have not seen for decades,” said Capital Group’s Steinbach. “Now is a great time to allocate, regardless of investors’ near-term views on the economy. Waiting too long could result in missing the opportunity. For institutional investors, this trend of wanting to have more robust allocations to public fixed income is going to continue.”
“The interest we have seen on the part of institutional investors has been dominated by core and core-plus allocations,” Steinbach said. “There’s a recognition that now is a good time to be increasing these allocations, particularly considering what the rest of investors’ portfolios look like in terms of heavy allocation to risk assets, alternatives and private credit. Investors are increasing core and core-plus exposure, where they’ve been under-allocated, recognizing that this is a good time to get those allocations back up.”
Steinaway at State Street said he expects institutional investors to increase their fixed-income allocations for two key outcomes, in the context of some plan sponsor portfolios. The first case is a derisking component for defined benefit corporate pension plans. “With correlations normalizing, positive equity returns and an increased probability of declining rates, pension plans are now in a position where they may be in surplus, or close to it, and where the market environment is supportive of a derisking transaction,” he said. In addition, “the income component of fixed income is back, [which] makes fixed income generally more attractive as part of a portfolio allocation. Derisking activities and a return to yield will be the two key drivers of fixed income demand over the near and intermediate horizons.”
On the private credit side, even though allocations have been climbing, investors should be looking more closely for selective opportunities. Institutional investors “should be positioned in a meaningful way,” said Gaito at Fidelity. “I think if you have questions about the economy, you need to think about whether you would rather be in equity or debt. For me, I’d rather be on the debt side, where I can get access to asset-level returns that are comparable to returns in the equity markets.”
T. Rowe Price’s Boothe also said that the window is open for institutional investors to leverage the new dynamics across the fixed-income market — public and private — but that doesn’t mean they can become complacent: “I do think that this is a window where you should be achieving your return targets via the bond market,” he said, pointing to average yields of 5% to 5.5% in traditional fixed income, around 6% in investment-grade credit and double-digit yields in private credit.
“You couldn't create that exposure several years ago,” he added. “As long as we stay in this type of yield environment, fixed income should grow as part of your overall allocation relative to 10 years ago.” Yet investors should be cautious, carefully watching structural and macro issues across the globe, such as “some of the more structural issues that we have across global economies around demographics and slowing global growth,” he said. “Maybe we don’t revisit zero bound, but I’m skeptical that we hang out at five-ish percent policy rates for an extended period of time.”
A pivotal time
The combination of interest rates coming off the zero-bound range and advances in market technology has made the argument that old and new fixed-income strategies, along with investment gains today, are not fly-by-night developments.
“This is a pivotal time for fixed-income markets, with the impacts of higher global rates and significant market structure changes now being fully realized,” said Steinaway at State Street. “Since 2008, there has been a transformation in fixed-income market structure — including the rise of ETFs, improved access to liquidity and increased electronic trading — that has been driving changes to how investors approach these markets. We’re just at the front end of these changes, all while experiencing a significant shift in client demand related to higher global rates, so it’s a fun time to be in business.”
Capital Group’s Steinbach said, “Revisiting asset allocation and public fixed income is likely to continue and result in a lot of money coming back into high-quality public fixed income, as we are starting to see so far this year. I think that trend will continue and even accelerate.”
For Boothe at T. Rowe Price, technology is the key. “The innovation — the technology that is taking place on the trading side of our business — is phenomenal,” he said. “There’s this rapid productivity-gain via a lot of fintech companies and other applications that that allow for more efficient sourcing and deployment of risk and liquidity. We’re going to see innovation leaps and bounds over the next couple of years around how we trade bonds. Those efficiencies and productivity can get passed on to our clients and into performance.”