CONTENT BLOCKS
The Institutional Investor’s Guide to Fixed Income P&I Custom Content in partnership with

INTRODUCTION

2023 may well turn out to be the “Year of the Bond,” as fixed income has experienced a dramatic turnaround driven by seismic shifts in the macro environment and central bank policy. Institutional investors of all stripes continue to closely parse signals from regulators and watch the latest economic indicators as they reassess the role of fixed income within their overall asset allocation.

“The Institutional Investor’s Guide to Fixed Income,” in partnership with MFS Investment Management, provides current insights into the macro and market factors driving the fixed-income market, and where it is headed. The guide highlights key characteristics of public fixed-income asset classes and makes a compelling case for active management. It also offers a unique view on how retirement plan sponsors and other institutional investors should think about fixed income going forward.

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I

State of the U.S. Market

Where we are...

Macro factors are driving fixed income — and all financial markets, for that matter. Starting in late 2021, investors have focused on the increasingly evident inflationary trend and the Federal Reserve’s interest rate increases to combat it. The annualized consumer price index peaked in June 2022 at 9.1% — its highest level in 40 years — and the soaring inflation and successive rate hikes severely devalued all financial assets that year. By July of this year, the effective federal funds rate had climbed to 5.25% from its near-zero level during the COVID pandemic as the Fed acted to help buffer the economy.

The story of the fixed-income market can be split into a narrative of “That was then, this is now.” Following the disastrous market performance of 2022, when the Bloomberg U.S. Aggregate Bond index fell 16%, the asset class has experienced a dramatic turnaround. Yet, with ongoing market challenges, fixed income investing today requires institutional investors to take a more thoughtful and nuanced investment approach to meet their risk-return objectives.

Macro factors and their potential impact on economic growth have continued to dominate investor sentiment well into 2023. Now investors also need to look at the implications for specific asset performance, according to Rob Almeida, global investment strategist and portfolio manager at MFS.

“The right focus should be on what has already happened and how it will affect future cash flows,” Almeida said. “How are higher interest rates going to affect consumers’ ability to spend when their mortgage payments and credit card balances are higher? How is that going to affect companies’ profitability, now that their funding costs are so much higher?”

Central bank interventions are only one piece of the puzzle. “I appreciate why the world is so focused on what central banks may do, but that’s somewhat immaterial relative to what they have already done and how that will affect households, businesses and, ultimately, financial assets,” Almeida said.

 

...And how we got here

To fully appreciate how rising interest rates are threatening corporate cash flows — therefore, credit quality — investors should remember that years of low rates set the table for what’s happening today. Funding was readily available to borrowers of all kinds, which also meant that weaker entities, which otherwise might have gone out of business, were able to finance themselves and stay afloat.

Put simply, market reality [had] changed from survival of the fittest to survival of the least fit.
Rob Almeida
MFS Investment Management

“If one believes that the function of financial markets is to efficiently allocate capital from weaker entities to stronger ones, then the lower-for-longer rate regime failed,” said Almeida. “Put simply, market reality [had] changed from survival of the fittest to survival of the least fit.”

The tightening interest-rate cycle has reversed this paradigm. Markets will reallocate capital from the least fit back to the fittest, in Almeida’s view, and fixed-income investors will need to focus on identifying the fittest companies and assets that can outperform in the tougher market environment.

As disastrous as 2022 was for fixed income, it also had a silver lining: It gave investors a chance to start fresh. Some market observers have called it “the great valuation reset.”

Almeida sees last year as an inflection point. “So much happened that changed the environment for bonds in 2022,” he said. “A land war in Europe, shrinking supply chains because of geopolitical risk, the pandemic. Inflation was out of the box and central banks could not subsidize profits and balance sheets any longer through low rates. All of this exposed the income fragility of companies that had been faking it, whether equity or fixed income, public or private.”

Read More: 'The Big Mac' on Macro Regimes: The Market Paradigm Shift

Bonds are back

2022’s biggest impact on fixed income is best captured by the simple phrase, “Bonds are back.”

Higher yields — whether caused by Fed tightening, falling bond prices or both — have helped restore the usefulness and appeal of the asset class. Bond income has retaken its place as a mainstay of retirement portfolios. Cash and short-duration instruments, once again, are desirable destinations for liquidity and low-risk assets. Potential alpha and expected total returns are more competitive than they’ve been in years.

Much has been written about 2022’s convergence of fixed-income and equity returns, which negated fixed income’s traditional role as a portfolio diversifier. The convergence called into question the traditional 60/40 allocation — 60% stocks for growth and 40% bonds for downside risk management — as all asset returns plunged. Correlations between equities and major fixed-income sectors significantly increased versus their historical levels.

In 2023, correlations thus far have somewhat reverted to their pre-2022 levels, meaning that fixed income is regaining its diversification capability. Fixed income should be an effective diversifier against equity stress if, as MFS expects, corporate profits fall; the dispersion between profitable and unprofitable companies rises, resulting in higher equity volatility; and bond yields remain at or near normal levels.

An improved diversification profile has positive implications for both 60/40 portfolios and, broadly, for multi-asset portfolios.

The Return of Diversification
Comparative view of fixed income correlations vs. the S&P 500 (basis points)
(For the 2003 to 2021 period vs. 2022 and 2023 YTD)
The Return of Diversification
Notes: All index returns are total returns. S&P 500 represented by S&P 500 Index. U.S. high-yield corporates represented by Bloomberg U.S. Corporate High Yield Index. Non-U.S. investment grade represented by J.P. Morgan GBI Global Index and J.P. Morgan EMBI Global Diversified Index. U.S. investment-grade corporates represented by Bloomberg U.S. Corporate Bond Index. U.S. mortgage-backed securities represented by Bloomberg U.S. Mortgage-Backed Securities Index. U.S. Treasuries represented by Bloomberg U.S. Treasury Bond Index. 2023 data is year to date as of June 30.
Source: MFS Investment Management
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II

Scope of the U.S. Market

Huge size and variety

Perhaps the single most important statistic about the U.S. fixed-income market is its size. The sheer quantity and variety of fixed-income securities present a universe of opportunities for active managers (see Section III).

There are 13,358 U.S. investment-grade securities, 1,967 U.S. high-yield corporate issues and 56,455 municipal issues1 whose total is nearly nine times the approximately 8,000 equities traded on U.S. stock exchanges.2

Equities have a bigger market value ($39.1 trillion3 versus $28.3 trillion for fixed income4), though, because their prices are uncapped — many shares trade in the hundreds or even thousands of dollars — while debt issues are priced relative to par to reflect their yield to maturity.

Size of U.S. Fixed Income Market
Number of securities
Size of U.S. Fixed Income Market
As of June 30, 2023. Sources: Bloomberg, J.P. Morgan.
U.S. Fixed Income Market Dwarfs U.S. Equity Market
Number of securities
U.S. Fixed Income Market Dwarfs U.S. Equity Market
Fixed income as of June 30, 2023. U.S.-listed stocks as of April 2023. Sources: Bloomberg, NYSE.
Composition of U.S. Investment-Grade Fixed Income Market
Market value = $25.5 trillion
Composition of U.S. Investment-Grade Fixed Income Market
Bloomberg U.S. Aggregate index as of June 30, 2023. Source: Bloomberg.

Investment-grade fixed income

Brad Rutan, managing director and market strategist at MFS, shared key characteristics of public investment-grade fixed-income sectors that investors should keep in mind as they consider allocations:
  • High interest rate sensitivity. Treasuries, investment-grade corporates and municipals have the longest maturities and, therefore, the most sensitivity to changes in interest rates as measured by duration.
  • Most liquid. Treasuries and investment-grade corporates also are the most liquid fixed-income sectors, making them especially desirable both for building positions and raising cash as needed.
  • Agency debt. Debt issued by U.S. government agencies (such as the Federal Housing Administration and Small Business Administration) and government-sponsored enterprises (Fannie Mae, Freddie Mac) offers high credit quality as well as potential opportunity for attractive incremental yield over comparable-maturity Treasuries.
  • Municipals. Municipal bonds are especially popular among retail investors. Income paid by most municipals is exempt from federal income tax, and some states exempt muni bond income from state and local income tax when purchased by in-state residents. Taxable municipal bonds have been used to refinance older bonds and to fund capital projects, such as those issued under the Build America Bonds, or BABs, program.
  • Securitized debt. Securitized debt is best exemplified by mortgage-backed and asset-backed securities, or MBS and ABS, as well as collateralized loan and debt obligations, or CLOs and CDOs. Backed by pools of underlying revenue streams, securitized issues typically have appealing yields and a tranche structure that offers different levels of credit quality, duration, risk and yield for investors with different objectives.
  • Non-U.S. debt. Non-U.S. debt comprises sovereign and corporate issues from developed and emerging nations. These are very large markets that can offer opportunity, but they tend to have higher duration and more volatility than U.S. issues. In addition, part of this market is issued in local currency, carrying currency risk that could be favorable or unfavorable to U.S. investors, depending on exchange rates.
 

Below-investment-grade fixed income

Rutan also cited noteworthy features of below-investment-grade sectors:
  • High yield. High-yield corporates have higher credit risk — thus higher yields — than investment-grade debt. On the other hand, they’re less interest rate sensitive, both because their maturities are shorter (typically no more than 10 years) and they’re often callable before maturity.
  • Municipals. Below-investment-grade municipal securities, just like high-yield corporates, have higher yields and credit risk compared with investment-grade bonds. Over 30% of municipal bonds that are issued come to market unrated, and the decision by a municipality to not obtain a rating is usually based on the likelihood of a below-investment-grade rating. Retail investors especially value debt issued by Puerto Rico, a major below-investment-grade borrower, for its exemption from federal, state and local income taxes.
  • Non-U.S. debt. While the sovereign debt of most non-U.S. developed nations is investment grade, approximately 40% of emerging-sovereign bonds are below investment grade.5 Many developed and emerging corporate issuers are below investment grade as well.
  • Distressed debt. Distressed debt is the existing debt of a financially distressed company, government or public entity. As distressed issues are highly risky, evaluating them using credit research is very important.
 

Private fixed income

Private debt is capital lent by nonbank entities to nonpublic companies, usually in the small and middle markets. It is typically investment grade and takes the form of floating-rate loans, which greatly benefits investors during periods of high rates and inflation.

But private debt has a major drawback when compared with public fixed income: Since it doesn’t trade, it’s not marked to market, and changes in valuations lag those of publicly traded securities. This lag can be a drag on portfolio returns in periods when rates fall and valuations of public fixed income improve.

Read: 'The Big Mac' on Fixed-Income Opportunities: What’s on the Menu?

Section II footnotes
1 Number of issues included in the Bloomberg U.S. Aggregate, Bloomberg U.S. Corporate High Yield and Bloomberg Municipal bond indexes as of June 30, 2023.
2 NYSE.com, April 2023.
3 Market value of the S&P 500 index as of June 30, 2023.
4 Market value of issues included in the Bloomberg U.S. Aggregate, Bloomberg U.S. Corporate High Yield and Bloomberg Municipal bond indexes as of June 30, 2023.
5 “Emerging Market Bond Index (EMBI) Monitor,” J.P. Morgan, June 2023.
 

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III

The Case for Active Management

Why active management?

“Fixed income is uniquely suited to active management,” said Rutan. “Compared to the equity market, where alpha is primarily driven by sector allocation and security selection, fixed income offers many more opportunities to generate alpha where, in addition to sector and security, you can generate excess returns through duration, country/curve management, quality and currency,” he said.

“The key to active management in fixed income is the sheer amount and scope of fixed-income instruments. The market’s scale and lack of uniformity create pricing inefficiencies that experienced managers can exploit,” he added.

Compared to the equity market, where alpha is primarily driven by sector allocation and security selection, fixed income offers many more opportunities to generate alpha.
Brad Rutan
MFS Investment Management

Rutan cited an additional contributor to fixed income’s potential alpha: The periods in which spreads have widened or tightened have become much shorter since the Great Financial Crisis. This has increased market volatility, enabling managers to find attractive tactical opportunities.

In the past 15 years, Rutan explained, “the amount of time it takes for spreads to go from peak to trough or trough to peak has shrunk. It used to take five-plus years on average for spreads to widen or tighten, and now it’s around 17 months” (as of June 2023).

In addition, “we’re getting four times as many tightening or widening events, which means four times the number of opportunities to add or reduce risk based on where valuations are. This really lends itself to active management. If you’re watching these markets and you’re disciplined around valuations, it’s a big alpha opportunity,” Rutan said.

 
Mini-Credit Cycles Have Emerged
Credit cycle dynamics have shifted post-GFC
Mini-Credit Cycles Have Emerged
Notes: GFC = Global Financial Crisis. Shaded areas represent periods of significant spread widening. Data from Bloomberg. Weekly data from 1 March 1991 through 12 May 2023. U.S. Investment Grade Corporate = Bloomberg US Aggregate Corporate index. OAS = option-adjusted spread. Source: MFS Investment Management.

MFS’ approach: research and specialization

“Investing is simple but hard. It’s simple in that cash flows drive prices of all financial assets, but hard because the future has no facts,” said Almeida. “MFS brings a large group of people with different coverages to think about an enterprise through a variety of lenses [in order] to expose as many risk factors as we can. Through this process, we aim to identify the ranges of potential outcomes for every company and asset, and we assess if we’re being appropriately compensated for those outcomes.”

For MFS, research is one is the core of the investment approach, how the firm adds value and a vital element of its culture. Active fixed-income management isn’t possible without it.

The key to active management in fixed income is the sheer amount and scope of fixed-income instruments. The market’s scale and lack of uniformity create pricing inefficiencies that experienced managers can exploit.
Brad Rutan
MFS Investment Management

A collaborative culture, in which analysts engage and work together across asset classes, underlies MFS research. While both fixed-income and equity analysts study cash flows, fixed-income analysts also focus on credit risk while equity analysts focus on earnings — thereby enhancing each other’s perspective. Together they can identify risks and opportunities they might not have seen individually. Exchanging ideas helps both sides think bigger and more deeply at the same time.

A good example of this collaboration is joint meetings between MFS equity and fixed income teams and company managements. CEOs, for example, want to speak to equity managers and analysts because much of CEO compensation is based on the company’s stock price. But the fixed-income team maintains ongoing updates on the company’s ability to service its debt. In MFS’ view, management will be more candid when it has to respond to equity and debt investors at the same time.

MFS believes that analysts are most effective as specialists, versus generalists. In fixed income, this approach means that analysts focus on specific debt sectors, industries (for corporate debt) and portions of the yield curve. Such specialization, in turn, allows the fixed-income team to look for value by comparing spreads in numerous areas, notably:
  • Within multiple securities of the same issuer (such as Treasuries and large corporates)
  • Among issuers of the same credit quality
  • Across quality tiers
  • Among issuers within the same industry
  • Across industries
  • Across geographies.

This highly specialized approach underscores the need for MFS’ fixed-income team to commit significant resources to research. Rutan noted that over the last decade, MFS has doubled its fixed-income research headcount so that its analysts grew from 30% to 40% of total investment staffing. The firm also maintains the importance of having analysts on the ground in different parts of the world so that it can meet in person with issuers almost anywhere.

In addition, “we’ve covered multiple publicly traded companies that went private by continuing to follow their debt. Some of these companies went public again, so that continuity of coverage can be very beneficial,” said Rutan.

“But you could also say that research is as vital in the private markets, because there’s less access to data. You don’t get the regular filings like you do in the public markets. You need skilled analysts to dive into companies, whether they’re public or private. Our analysts cover both,” he said.

Read: The Renaissance of Active Management

Passive management

At first glance, passive management might not make sense for fixed-income portfolios. The same huge quantity and variety of debt issues that favor an active approach can appear too unwieldy for passive replication.

Yet passive fixed-income vehicles have gained popularity in recent years, as institutional and retail investors have sought cost-efficient ways to achieve market-level exposure. The share of passive fixed-income AUM has risen to 37.6% of that of total fixed income as of June 30, 2023, up from 30.8% in June 2020, according to data from Morningstar.

Unlike with equities, duplicating a broad fixed-income index, such as the Bloomberg U.S. Aggregate Bond index, is virtually impossible. The solution is to create a portfolio that mimics the index’s sector, duration/maturity, credit quality and yield characteristics as closely as possible.

In Rutan’s view, the growth of passive is a long-term trend — and favorable for active managers as well. “Passive exposure is rising,” he said, “and it’s going to be a part of the market forever. As more flows go into passive, it should create more inefficiencies and opportunities for active managers to exploit, based on how passive bond indices and [exchange-traded funds] are constructed.”

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IV

Strategies and Opportunities

As institutional investors continue to seek help navigating macro impacts on fixed-income markets and reassess their allocations to meet their return targets, MFS’ active investment approach takes into account each plan sponsor’s overall portfolio profile and objective. Both defined benefit and defined contribution plans can evaluate opportunities for diversification and return.

Example 1: Global bonds can add value with an LDI strategy
Traditional liability-driven investing approaches use a combination of Treasuries and U.S. investment-grade credit to create portfolios with duration profiles comparable to the pension plan’s liability. In many cases, derivatives — such as futures and swaps — are used to extend duration and fill in any “gaps” in duration that cannot be covered with physical bonds.

We believe that global bonds are best accessed through an active approach that can potentially produce relatively attractive returns through blending risks globally across credit, rates and currency.
Rob Almeida
MFS Investment Management

As DB plans mature and the participant population ages, liability duration naturally decreases. Higher rates also reduce duration, and with pension discount rates increasing by over 200 basis points in 2022, typical liability duration has decreased by two to three years. This lower-liability duration profile potentially allows for more liability to be covered with physical bonds and to reduce derivatives exposure. That can be appealing as it lowers liquidity and counterparty risks, while also lessening the governance oversight for derivatives.

While the first stop on the route to higher allocations of physical bonds are the usual suspects of U.S. Treasuries and credit, other asset classes such as global investment-grade bonds could also play an important role in an LDI portfolio. Non-U.S. dollar denominated bonds — representing more than half of the Bloomberg Global Aggregate Bond index, with over $36 trillion of bonds issued in euros, yen and other currencies — provide a broad opportunity set for investors.

With non-USD investments, investors must consider currency risk. A U.S. DB plan would typically hedge out non-USD exposure so that assets and liabilities are denominated in the same currency. In the current market environment, hedging non-USD exposure, including euros and yen, has a negative cost that can benefit U.S. investors.

MFS’ analysis found that in order to consider the suitability of global bonds in a U.S. DB plan, sponsors need to consider their duration characteristics and correlation with plan liabilities and other commonly used assets.

Correlation of Global Bonds to Common LDI Asset Classes
Correlation of Global Bonds to Common LDI Asset Classes
Notes: FactSet Correlations based on monthly returns from June 30, 2013, through June 30, 2023, for the following indices: Bloomberg Global Aggregate Bond index (hedged to USD), Bloomberg U.S. Aggregate Bond index, Bloomberg U.S. Aggregate Credit — Intermediate index, Bloomberg U.S. Aggregate Government & Credit — Long index, Bloomberg Global U.S. Treasury index. Source: MFS Investment Management.

MFS found a high correlation between global bonds and assets often used in LDI portfolios. Taking this a step further, it examined the correlation between global bonds and a hypothetical liability-hedging portfolio of assets comprised of 40% U.S. Treasuries, 30% U.S. intermediate credit and 30% U.S. long government credit that could hedge a hypothetical liability with a duration of roughly eight years. The correlation was 0.95, suggesting that adding an allocation of global bonds to the portfolio would not upset its overall liability-matching profile.

Over the past 10 years, global bonds have generally kept pace with the hypothetical liability-hedging portfolio over rolling three-year periods and have slightly outperformed that portfolio with an annualized return of 2.11% versus 1.95%.1

“While the Bloomberg Global Aggregate Bond index is a useful proxy for global bonds, we feel that a passive approach is not optimal to access the asset class,” Almeida said. “We believe that global bonds are best accessed through an active approach that can potentially produce relatively attractive returns through blending risks globally across credit, rates and currency.”

In addition, he noted, global spread sectors can diverge and provide investors with potential source of alpha. “We believe returns can be enhanced by diversifying bond allocations across corporate, government, emerging market and securitized sectors and choosing the strongest government and credit bonds within each of those sectors, Almeida said. “These alpha levers can be applied while still maintaining a duration profile appropriate to meet the plan’s objectives.”

Example 2: Diversifying fixed income can improve target-date fund performance
Many investment managers and wealth advisors believe that as investors approach and enter retirement, they should maintain a strong equity allocation in their defined contribution plans. The underlying idea is that investors will need growth-based assets to generate additional capital as their retirement savings dissipate.

The flip side of this argument, of course, is that fixed-income allocations should decline as equity allocations rise. To determine whether this is correct, MFS conducted an analysis of target-date fund performance over the past 15 years — a period that includes three years of significant equity drawdowns in 2008, 2018 and 2002. Please see MFS Assumptions and Methodologies at the end for additional information.

MFS’ conclusion was simple and clear: Target-date funds with well-diversified fixed-income allocations fared much better than their less-diversified counterparts.

In light of this research, DC plan sponsors should consider taking a fresh look at fixed-income diversification within their target-date glidepaths to ensure alignment with participants’ retirement savings objectives.

Read White Paper: Revisiting the Role of Fixed Income Along the Retirement Savings Journey

Section IV footnote
1 Source: FactSet based on monthly returns from June 30, 2013 through June 30, 2023 for the Bloomberg Global Aggregate Bond index (hedged to USD) versus a hypothetical portfolio comprised of 40% Bloomberg Global U.S. Treasury index, 30% Bloomberg US Aggregate Credit – Intermediate index, 30% Bloomberg U.S. Aggregate Government & Credit – Long index.
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V

What Lies Ahead

Fixed-income investors today need to be far more discerning and selective in understanding and navigating the markets — and uncovering opportunity.

Cash flow is king

“Higher rates, higher labor costs, onshoring, climate change, all of this is costing companies more money,” said Almeida. “It raises capital intensity, which then reduces the return on the business. Whether you own the equity or the debt, if that company is no longer economically viable because it can’t survive in this more competitive world, that’s what’s most relevant.”

How slowing growth and rising costs flow through profit-and-loss statements is what’s going to drive the credit and equity markets going forward.
Rob Almeida
MFS Investment Management

Today, Almeida added, “it’s about individual companies, individual disparities. If an enterprise isn’t fungible in this different world, then its stocks and bonds are going to perform badly, regardless of what the Fed does.”

It’s fair to say that fixed-income managers are laser focused on interest rates, the economy and Fed monetary policy — especially in times like the present. They have to be focused this way in order to have a macro view and construct sound portfolios, right?

Not so, according to Almeida. While macro drivers and the Fed certainly are important, they are pieces of a much larger mosaic in which the effect of aggressive Fed tightening is only beginning to be felt — an effect that undoubtedly will be negative in the form of tightening credit conditions and slowing growth. What’s most important now is whether individual issuers can generate sufficient cash flow to service and pay off their debt.

Fed-focused investors are missing the point, he said. “Growth is slowing and revenues are falling. The cost of capital has taken a step function upward, higher than it has in 40 years. Labor costs, which are a company’s biggest expense, have taken a huge jump as well. How all of that flows through profit-and-loss statements is what’s going to drive the credit and equity markets going forward. Investors will distinguish between companies that can at least cover their cost of capital and those that can’t.”

Almeida noted that in 2006 and 2007 — the last time rates were as high as they currently are — MFS’ fixed-income analysts helped the firm’s equity analysts incorporate higher borrowing costs into their earnings calculations and stress-test their cash flow models. While conditions are different today, he believes investors should stress-test their models once again.

The upshot of all of this for plan sponsors and their fixed-income managers: Strategies that may have worked in the last decade may be much less successful in the next one. It may be time to rethink the approach.

Use alpha levers

“While the normalization of interest rates since 2022 has exposed small pockets of stress in fixed income, we see more unintended and unwelcome consequences to come. We think this new environment should set the stage for a multiyear transition in leadership from nondiscretionary portfolios to fundamentally oriented active strategies and potentially create significant opportunities for alpha generation,” Almeida said.

MFS expects conditions for fixed-income returns to be more muted going forward. Between the start of the GFC and the end of 2021, falling rates created a strong beta-driven environment in which a rising tide lifted all boats. The higher-rate, lower-profits environment that MFS foresees is likely to lead to more volatility and dispersion in credit markets — which we think is an attractive time for active management.

We think this new environment should set the stage for a multiyear transition in leadership from nondiscretionary portfolios to fundamentally oriented active strategies and create significant opportunities for alpha generation.
Rob Almeida
MFS Investment Management

Alpha should become a vital component of overall total return, and selectivity will be crucial. Investors have many alpha levers, notably regional allocation and the selection of sectors, styles, securities and managers.

Investors also need to dig more deeply into security selection, and Almeida points to U.S. bankruptcy filings as a harbinger of credit deterioration. He noted 127 filings through July 31, 2023, by companies with liabilities greater than $50 million. Comparing the pace of filings, on an annualized basis, to other recessionary periods such as 2020, when the COVID lockdown slashed GDP by nearly one-fifth, and 2009, during the GFC, it signals that the effects of tightening financial conditions are slowly being felt in the real economy.

The acceleration in bankruptcies is the natural consequence of low rates and relatively cheap labor costs that enabled companies to artificially inflate their profit margins — and cash flows — prior to 2022, Almeida said. When this impact becomes more widespread and investors become more disappointed in such companies, “it will catalyze a multiyear revolution for actively managed portfolios, as a more difficult future operating environment separates the winners from the losers.”


Accelerating Bankruptcies Point to Credit Deterioration
Bankruptcies on Pace to Exceed COVID-Era Spike
Accelerating Bankruptcies Point to Credit Deterioration
Note: Bloomberg data as of 31 July 2023. Number of bankruptcy filings calculated for each calendar year. 2020 bankruptcy filings is from 1 January 2023 through 31 July 2023 and is annualized (unannualized figure = 127 filings). Companies included in the count are those with liabilities greater than $50 million.
Source: MFS Investment Management.

Focus on credit quality

How should plan sponsors think about positioning in their overall portfolios? In MFS’ view, be as defensive and conservative as possible. For its multisector income portfolio, that means overweighting fixed income and underweighting equities.

It also means taking a duration stance that is surprisingly long. While a defensive posture would suggest keeping duration fairly short, Almeida is more concerned with credit risk than with interest rate risk. “If you can identify an issuer with good credit quality, you can worry less about the bond’s duration,” he said. “A strong credit simply will translate into the issuer being better able to repay its debts, whether it’s in the near term or longer term.”

He added, “To the extent that the effects of higher interest rates and higher labor costs have a more dramatic effect on the economy than we expect, such as a stronger recession, then short-duration fixed income isn’t going to give enough downside risk management to an equity portfolio. As recession risks mount, you want more duration, assuming that your credit quality is very high.”

Sector preferences

MFS’ multisector income portfolios, within fixed income, are overweight high quality and duration. For example, the biggest overweight allocations are generally to AAA-rated government securities and investment-grade corporates. High-yield corporates are the biggest underweight.

Technology subsectors, particularly those related to artificial intelligence, are a key area of focus. AI is growing six times faster than Moore’s law, which holds that the speed of semiconductor chips doubles every 18 to 24 months. Beneficiaries of this growth include data centers, co-location and a variety of equipment — the “pickaxes and shovels” that service the AI industry.

Turning the page on private debt

Plan sponsors have found private debt increasingly appealing in recent years. Its floating-rate structure has made it an attractive hedge against rising interest rates and inflation, leading plans to raise exposure accordingly.

Performance has been very strong as well. As represented by the Cliffwater Direct Lending index, private debt has significantly outperformed the Bloomberg U.S. Aggregate Bond index nearly every year since 2005, when rates were low and investors looked for yield wherever it was available.

Private Debt Outperformance
(% return)
Private Debt Outperformance
Source: Cliffwater LLC

Private debt continues to make sense in multi-asset portfolios, Almeida said, though it may be prudent for institutional investors to reduce their private debt allocations going forward.

The great valuation reset of 2022, referenced earlier, means that public fixed-income yields are much more competitive with those of private debt, Almeida said. As a result, private debt’s floating-rate structure — which proved so compelling when rates and inflation accelerated — should lose much of its appeal as rates stabilize or decline.

Another aspect of private debt, its lack of trading, can be doubly problematic for investors, Almeida said. First, in his view, the absence of daily pricing suggests that private debt’s presumed diversification benefit for public fixed income is illusory. Second, the dearth of liquidity renders it less useful for institutions with significant liquidity needs.

Read More: A New Paradigm for Institutional Investing

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VI

GLOSSARY

Alpha
Excess return of an asset or portfolio relative to the benchmark return. See beta.

Below investment grade
A corporate credit rating with lower levels of creditworthiness and higher likelihood of default on bonds and debt obligations, issued by the recognized rating agencies. The spectrum for below investment grade is BBB- or lower (Standard & Poor’s; Fitch Ratings) and Baa3 and lower (Moody’s). See investment grade and high yield.

Beta
A measure of the volatility of an asset or portfolio compared with the market or investment category. It refers to the asset’s systematic risk, market risk, nondiversifiable risk or hedge ratio. Beta helps evaluate how an asset could move, on average, when an overall market rises or falls. See alpha and correlation.

Cash flows
The interest or dividends, and sometimes amortization of principal, paid to investors in exchange for holding fixed income securities or instruments.

Collateralized debt obligation
A structured asset that is backed by an underlying pool of debt or loan payments. Different tranches, from senior to junior, are based on the risk levels of underlying assets. Types of these derivatives instruments include mortgage-backed securities, which are backed by mortgage loans; and asset-backed securities, which are backed by auto loans, credit card debt and other debt. See collateralized loan obligation and securitized debt.

Collateralized loan obligation
A structured asset that is backed by an underlying pool of corporate loans, usually senior loans — also known as bank loans or leveraged loans — which are senior in a corporation’s capital structure and thus paid first in the event of a bankruptcy. CLO tranches are based on the underlying assets’ risk levels or credit ratings. See collateralized debt obligation and securitized debt.

Correlation
A measure of the degree to which two assets or two asset classes perform relative to one another. A coefficient, or beta, of 1.0 indicates a perfect positive correlation. That is, as one asset class moves higher or lower, the other moves in the same direction. A negative, or inverse, correlation means that two asset classes move in opposite directions, which is desirable for diversification. See beta.

Cost of capital
A measure of expected return and the discount rate in fixed-income investing.

Duration
The average time it takes to receive all the cash flows of a bond, weighted by the present value of the cash flows. Duration also measures the price sensitivity of a bond to changes in interest rates. When interest rates rise, the higher a bond’s duration, the more its price is likely to fall.

Floating-rate debt
Debt instruments that have variable interest rates, versus fixed-rate instruments that have interest rates that don’t fluctuate. Interest rates for floating rate instruments are usually tied to a benchmark rate, such as the federal funds rate or Secured Overnight Financing Rate, plus a quoted spread. See private debt.

High yield
A corporate credit rating that indicates a higher likelihood of default on bonds and debt obligations, issued by the recognized credit rating agencies. The higher risk on high-yield bonds is compensated by higher interest payments, or yield. Also called junk bonds, which tend to have higher price volatility. Ratings are BB+ or lower (Standard & Poor’s; Fitch Ratings) or Ba1 or lower (Moody’s). See below investment grade and investment grade.

Investment grade
A corporate credit rating that indicates the highest levels of creditworthiness and lowest likelihood of default on corporate bonds or debt obligations, issued by the recognized rating agencies. The spectrum of investment grade is AAA to BBB- (Standard & Poor’s; Fitch Ratings), and Aaa to Baa3 (Moody’s). See below investment grade and high yield. See below investment grade and high yield.

Moore’s law
The tenet that the number of transistors in an integrated circuit doubles approximately every two years while the cost of a computer is halved. It is based on an observation by Intel co-founder and former CEO Gordon Moore and means computational progress becomes faster, more efficient and less expensive over time.

Private debt
Debt financing provided to companies by private entities, such as hedge funds, private equity and private debt asset managers. Also called private credit, of which a subset is direct lending. Types include senior-secured loans, unsecured credit, specialized loans and distressed loans. Typically floating rate and illiquid, with an active secondary market.

Securitized debt
Structured securities that are backed by multiple pools of debt or loans. Common types include: mortgage-backed securities, comprised of pools of residential or commercial mortgages; and asset-backed securities, comprised of auto loans, credit card debt or other nondebt assets that generate cash flow. See collateralized debt obligation and collateralized loan obligation.

Tranche structure
A common structure for securitized debt products, such as a CDO or CLO, that segments the underlying debt by risk or other characteristics. Each portion, or tranche, carries a different degree of risk, maturity, yield and privilege in case of default. See collateralized debt obligation and collateralized loan obligation.

Yield curve
A visual graph that plots the yield of long-term and short-term bonds against their maturity dates. The x-axis reflects the term to maturity and the y-axis depicts the expected yield.

section-8-separater
VII

Quiz

Test your knowledge on fixed income based on the information provided in this Guide. It offers a brief recap of key areas of information related to fixed income.

 
MFS Assumptions and Methodologies
Our analysis assumes that all three participants had a retirement account balance of $1 million on January 1, 2022, and made no contributions to their account in 2022. Upon retirement, each participant intended to generate a level annual retirement income from their account over the next 20 years. Analysis assumes that each participant retires on December 31, 2022, and makes the first withdrawal in 2023. The hypothetical annual retirement income derived from the account is based on a 20-year level annuity payable at the beginning of the year using a discount rate of 4%. Returns for hypothetical portfolios based on weights and indices shown below. All returns are total returns.
Portfolio A is made up of 60% equity and 40% fixed income: 50% S&P Total Return index, 10% MSCI ACWI index, 40% Bloomberg Barclays U.S. Aggregate Bond index.
Portfolio B is made up of 30% equity and 70% fixed income: 25% S&P Total Return index, 5% MSCI ACWI index, 70% Bloomberg Barclays U.S. Aggregate Bond index. Portfolio C is made up of 30% equity and 70% diversified fixed income: 25% S&P Total Return index, 5% MSCI ACWI index, 10% Bloomberg Barclays U.S. Aggregate Bond index, 10% Bloomberg U.S. Aggregate 1-3 Year index, 2.5% J.P. Morgan EMBI Global Diversified index (Hedged), 2.5% Bloomberg Barclays U.S. Corporate High Yield index, 10% Bloomberg Barclays U.S. Treasury Inflation-Linked Bond index, 10% Bloomberg Barclays U.S. Government index, 5% Bloomberg Barclays Global Aggregate index, 20% FTSE 3 Month U.S. T-Bill index.

The views expressed in this article are those of MFS and are subject to change at any time. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading intent on behalf of any MFS investment product.
Investments in debt instruments may decline in value as the result of, or perception of, declines in the credit quality of the issuer, borrower, counterparty, or other entity responsible for payment, underlying collateral, or changes in economic, political, issuer-specific, or other conditions. Certain types of debt instruments can be more sensitive to these factors and therefore more volatile. In addition, debt instruments entail interest rate risk (as interest rates rise, prices usually fall). Therefore, the portfolio's value may decline during rising rates.
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