A fixed-income strategy to weather any landing

Fixed-income investors are navigating a higher-for-longer interest rate environment, as the resilient U.S. economy keeps inflation running high.

“The market has been pushing out the start of the rate-cutting cycle based on the strong economic growth in the U.S., as well as the stronger-than-expected inflation numbers we’ve received more recently,” said Jeffrey Mayberry, fixed-income asset allocation strategist and portfolio manager with DoubleLine Group in Los Angeles, in a mid-April interview.

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In the U.S., inflation ran above the Fed’s 2% target for the third straight month in March. The Federal Open Market Committee meets this week, but a rate cut isn’t expected until later this year.

If rates were to remain high for longer, “maybe that increases the probability that the Fed is going to engineer a recession,” Mayberry said. “If that’s the case, then you should see, maybe, that longer-term interest rates would fall on those recession worries.”

As things stand, rates have moved up all along the yield curve, he noted, and expectations are for a soft landing, in which inflation is tamed without a recession, or no landing, in which the economy continues to grow and higher inflation persists.

However, “the fact that [the Fed] has to leave rates higher for longer increases the probability of a harder landing than otherwise would be the case,” Mayberry said.

His fixed-income strategy is to prepare portfolios to weather any storm.

“We don’t know if we’re going to get a recession in the latter half of 2024,” Mayberry said. “We don’t know if we’re going to get a soft landing or a no landing scenario. So, we’re really trying to put portfolios together that can do well in both.” 

In a no landing scenario, fixed-income investors will want some credit risk, he said.

“You want to have that yield pickup … whether it’s from high-yield corporate bonds or emerging markets or structured credit,” he said.

Also, a “big portion” of fixed income should be allocated conservatively, he said, in “flight to quality–type securities, whether it’s in longer-duration U.S. Treasuries or in agency mortgage-backed securities.”

In a recession, the flight to quality portion will be the better performer, while credit spreads will widen, he noted.

“So, you have to have that balance,” he said. “Not having a one-sided view of which way the market is going to go, creating a more balanced view and more balanced portfolio that is able to do well under those two disparate scenarios.”

Mayberry was cautiously optimistic on specific fixed-income opportunities, given relatively higher ylelds.

“Now, you’re looking at places where there are opportunities across the fixed-income market,” he said. “[You’re] able to pick and choose where to take those opportunities; which sectors you want to overweight, which sectors you want to underweight is paramount.”

Mayberry suggested a selective approach, favouring structured credit sectors, where risk-reward dynamics remain favourable. He cited commercial mortgage-backed securities, non-agency residential mortgage-backed securities, and asset-backed securities.

“We really like the commercial mortgage-backed security space,” he said. “Spreads are still very wide.”

And investors have options beyond office space and retail malls. “You can invest in industrial spaces or hotels or even multifamily,” which all fall under commercial mortgage-based securities, Mayberry said.

“There are opportunities to take good fundamental risks at wider spreads, which is always the goal,” he said. 

Despite the opportunities, the market is not without risk.

“Certainly, if the Fed is staying at this higher-for-longer rate level, the risks of a recession are increased,” he said.

He also noted the risk of chasing yield.

“People are really in a place where they are trying to take advantage of these higher rates overall, these higher yields … that you’re getting in credit sectors,” he said. “That leaves the higher probability of you being less compensated for the default risk that may be in some of these securities.” 

Defaults in corporate credit and high yield could emerge in the latter half of 2025, he said.

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