David Furey, head of fixed-income strategists at State Street Global Advisors, has clear advice for institutional fixed-income investors: Favor the shorter end of the yield curve and emphasize high-quality assets.

Historically, Furey noted, longer yields are mainly driven by inflation and growth, while the curve’s front end is most affected by the Federal Reserve’s monetary policy. “There is a strong relationship between curve steepening and the kind of environment we’re in now. The curve typically steepens driven by the front end falling when the business and interest rate cycles are in advanced stages, as they currently are,” he said. “With the rate cycle more skewed to cuts at this point, we like the front end and are concentrating on the one-to-five-year area.”

Widespread anticipation of Fed easing has waned through much of 2024, Furey pointed out. “But if investors begin to price in cuts again, there’s potential for a decent rally at the front end, maybe 70 basis points or so. Whereas on the back end, there are more variables that can come into play. We therefore believe that the front end out to five years is a good place to sit out any volatility and then benefit further if and when cuts materialize,” he said.

Furey’s macroeconomic view underscores his stance on the yield curve and sector selection. In a nutshell, he expects interest rates to stay higher for the next few months before turning lower.

“Today’s higher yields have been justified by the inflation outlook and the economy’s strength as reflected by wage gains and robust employment numbers,” he said. “We had been in the camp of multiple rate cuts happening this year, but that looks increasingly less likely. However, we think the Fed will keep rates where they are for a bit longer and certainly not hike any further. Its role is to remain restrictive and slow the economy down. Eventually it will need to ease, and the market is very aware of that.”

As far as the timing of an initial easing move, Furey cited two reasons why it is likeliest to come in late 2024. First, current data on growth, employment and inflation has persuaded the Fed to rule out any cuts in the near term. Second, heading into the fourth quarter, the Fed would probably shy away from any rate moves because the action might be perceived as being driven or affected by the presidential election. The Fed’s Open Market Committee meeting in December, therefore, becomes the most realistic opportunity for the first cut.

With the rate cycle more skewed to cuts at this point, we like the front end and are concentrating on the one-to-five-year area.

David Furey

State Street Global Advisors

Geopolitical risk — exemplified by the Gaza and Ukraine wars and potential election-related market volatility — is very much on the minds of institutional investors. While geopolitical risk is usually considered a negative for financial markets, Furey believes it could be positive, particularly for U.S. assets.

“We see the risk-off sentiment that would likely result from any of these risks as something that would drive rates lower, as Treasuries would undoubtedly benefit from a flight to safety,” he said. “As a result, we think that now is not the time to be underweight U.S. assets or U.S. duration in global portfolios. If geopolitical risks come to the fore and market volatility spikes, they’re likely to drive outperformance of high-quality U.S. assets. Those assets should do well in a scenario of heightened volatility and increased geopolitical risk.”

Furey likes high-quality U.S. assets — particularly investment-grade credit — not only for their solid fundamentals, but also for their attractive all-in yields to maturity. The fact that valuations are on the high side is thus less of a deterrent than it might normally be.

Spreads on investment-grade corporate bonds, for example, are historically tight at around 90 basis points. This leaves the bonds with little cushion against downside risk and limited potential for further appreciation. But Furey noted that spreads are tight precisely because investors want to hold high-quality fixed income that offers attractive all-in yields.

Pension portfolios are especially appropriate for investment-grade credit, he noted. “Investment-grade credit currently yields around 5.5%, which is a very attractive level for pensions that are fully- or close-to-fully funded. These all-in yields essentially give them the carry they need relative to their liabilities.”

U.S. bank loans are another area that offers opportunities, Furey added. They include floating-rate loans that are secured, have good credit quality and positive exposure if rates rise; and loan indexing, an SSGA strategy, that “we think can deliver a loan allocation more efficiently than active management with much lower fees.”

Outside the U.S., Furey finds opportunities in high-quality, euro-denominated European government bonds and hard-currency emerging market debt. His investment thesis for Europe is that inflation is fading and the European Central Bank has already started to cut rates — meaning that there is greater potential, on a tactical basis, for yields to fall in Europe versus the U.S.

Several factors bode well for emerging market debt in hard currency, typically in U.S. dollars, according to Furey. Valuations are attractive, yields are compellingly high, prices would likely rise when the Fed cuts U.S. rates and many country issuers have restructured their finances, which improves credit quality.

Sophisticated investors today are seeking more precision in meeting their fixed-income portfolio objectives, whether that’s diversification, income or liability-matching, Furey said, and they’re employing both active and indexed paths. SSGA’s active methodologies include a traditional fundamentals-based approach and a systematic, factor-based investing approach.

The systematic strategy evaluates and ranks securities based on several key factor signals such as value, momentum, and sentiment. When combined, these signals have been shown to drive excess returns in credit portfolios. “Systematic active can harness the vast data that’s now available in the markets and analyze it all at scale and speed,” Furey said. “This has been made possible by the significant advances in electronic trading that have modernized how bonds are traded today.”

“A systematic strategy complements a traditional fundamental active strategy quite well,” he continued. “Traditional active approaches in credit employ credit analysis and fundamental research to make sector calls and select individual securities. This approach can be prone to certain biases. By contrast, a systematic approach is rules based and strictly quantitative. It provides alpha potential that can compete with good fundamental managers. It’s also a nice diversifier because its signal-driven construction provides a differentiated return profile with low correlation to fundamental manager performance.”

On the indexing side, SSGA sees higher demand for custom exposures that take a building-block approach to market beta. While in the past, investors held the Bloomberg US Aggregate Bond index, “now they’re disaggregating the Agg and building back their fixed-income portfolio in a more targeted and precise way,” Furey said. That, in turn, has led investors to hold a core indexed approach and a satellite active approach that can deliver more cost-effective and customized exposure management to the overall portfolio.

Investors’ views on the timing of the next shift in interest rates are mixed. While many expect the Federal Reserve to embark on cutting rates later in 2024, others see rates staying at their current relatively high level for a longer period.

Steve Boothe, head of investment grade and a fixed-income portfolio manager at T. Rowe Price, is firmly in the higher-for-longer camp. “We think there’s an upward bias to the yield curve, and that the curve will drift a bit higher over the next several quarters,” he said.

An important variable, according to Boothe, is volatility, both specifically for rates and generally. “Volatility is appropriately priced relative to where risk assets are priced, and if you look at broader measures of risk-asset volatility, they’re about where you would expect them to be,” he said. “We expect the volatility of rates to stay fairly contained, which points to a reasonably constructive macro environment that benefits fixed income.”

Boothe said he disagrees with the widely accepted thesis that inflation is steadily declining and will grind back to the Fed’s 2.0% target. Nor does he believe that inflation will meaningfully reaccelerate or reach new highs in the remainder of this year.

Economic growth is healthy and should stay that way, Boothe said. “We see the economy decelerating off of elevated growth levels, but not into something more pernicious that looks and feels recessionary. In other words, it should be relatively robust. The labor market should remain in good enough shape to maintain growth at that level, which should keep the macro environment comparatively benign,” he said.

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How should institutional allocators position their fixed-income portfolios along the yield curve? Boothe’s views on rates, inflation and growth underscore T. Rowe Price’s preference for the short end — and thus the firm’s duration underweight.

T. Rowe Price’s view is that the curve should rise somewhat over the near term. In this context, Boothe explained, the easing of economic growth from recent highs isn’t disinflationary and should put modest upward pressure on rates — or at least put less downward pressure on inflation — relative to the consensus. “When you have reasonable nominal growth, inflation that’s maybe stable to slightly higher and a Fed that has told you that it’s going to be patient, that adds up to a marginally higher and steeper yield curve,” he said.

We expect the volatility of rates to stay fairly contained, which points to a reasonably constructive macro environment that benefits fixed income.

Steve Boothe

T. Rowe Price

The higher-for-longer environment doesn’t bode well for risk taking in fixed income. Yet a risk-off approach isn’t necessarily appropriate either.

One potential consequence is that Treasuries won’t offer much upside. But Boothe sees opportunities elsewhere. “We think that higher-for-longer presents a reasonably constructive environment for investment-grade credit, particularly shorter-dated issues,” he said. “Since high-quality credit spreads are currently tight, it’s hard to make an argument based on valuation. But we also think that credit spreads could narrow further from here. If you can buy high-quality bonds at between 5.5% and 6.0%, as you can today, that’s pretty attractive.”

Within investment-grade credit, Boothe is especially positive on securitized debt, certain structured loans and euro-denominated securitized assets. Asset-backed securities provide attractive relative valuations versus investment-grade corporates, he said. Single- and double-A-rated asset-backed securities offer incrementally higher yields with similar-to-less credit risk.

Investors could also consider complex, esoteric loans with securitized structures, but not traditional credit card or auto-related asset-backed securities, Boothe said. Typically, these are unregistered, fairly illiquid secondary loans. As most of these loans are held by banks that must sell them to comply with regulatory and capital limits, they are available at compelling prices to suitable buyers, such as institutions, insurance companies and other buy-side investors, he noted.

As for euro-denominated securitized assets, Boothe sees an encouraging macro picture: greater economic growth and prospective upside in Europe compared with the U.S. In addition, the European Central Bank — unlike the Fed — has already begun to cut its benchmark rate. In addition to securitized assets, there is opportunity in subordinated bonds issued by European banks.

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While the macro environment is benign, fixed-income investors must address potential portfolio risks across any environment. Currently, among the most significant risks is the potential for inflation to reaccelerate.

“We don’t expect a reacceleration, but we can’t rule it out and still have to be prepared for it,” Boothe said. “In the event that it does happen as we make our way into the back half of the year, if we enter an environment where we’re back to 4.0% to 4.5% headline inflation, the market is mispricing that risk. Most investors are betting against it, but it’s possible. Institutional allocators and managers ignore it at their peril.”

In addition, Boothe said he believes there is overvaluation in some of the higher-rated tiers of high yield, although he’s not bearish on the segment. He sees elevated spread compression among double-B issues, which makes them potentially rich relative to triple B’s.

Monetary policy risk is also an issue. “As investors, we spend a lot of time thinking about rate policy. How many cuts or hikes will be priced into the market? When will the first cut be?” he said. “We spend less time talking about the Fed’s balance sheet, which we would argue is of importance as well. What is the balance sheet’s composition? Does the Fed move to a shorter-duration stance as long-term mortgages play less of a role on the balance sheet?”

While T. Rowe Price is an active manager of fixed income and equities, it recognizes that passive strategies have an appropriate place in large portfolios, Boothe said. But the standard concept of active versus passive — active aims to beat the benchmark and passive aims to duplicate it — is more nuanced than at first glance.

The key to either approach is to manage for outcomes that investors want to achieve. “When you’re constructing solutions for clients, you’re looking for specific outcomes or payouts. While these may not necessarily be against a benchmark, they are very active and customized solutions that seek to solve a particular problem or implement a particular idea,” he said.

Additionally, Boothe emphasized that active strategies give managers the flexibility they need to generate returns and mitigate risks. Credit managers, for instance, should be able to think globally to diversify against differing credit and policy cycles, and to avoid static duration positioning.

“In a world where volatility is currently benign but will certainly be more volatile on a go-forward basis, liquidity risk is becoming increasingly episodic and nontrending; policy risk is becoming less predictable; and new asset classes and instruments — private, securitized, IG corporates — are proliferating,” he said. That requires both active management and a customized-solutions approach in order to deliver the desired portfolio outcomes for each institutional client.

P&I's Fixed Income & Credit Conference, to be held on Sept. 24 in Chicago and Sept. 26 in New York, will bring together a pan-institutional group of asset allocators to discuss a range of approaches to fixed income across the public and private markets. Whether for income generation, defensive or, increasingly, return allocations, asset owners and industry providers share timely and forward-focused strategies across the fixed income markets.