A Fixed-Income Strategy to Weather Any Landing

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Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves. 

Jeff Mayberry, portfolio manager for DoubleLine Capital. 

We’re in an interesting place in the markets today with the rate cuts, the market having priced in so many rate cuts at the beginning of the year, and now 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 that we’ve received more recently. 

And I think currently, as of mid-April, that the market is pricing in under two rate cuts for the rest of the year, a broad divergence from when the market was pricing in seven rate cuts earlier this year or late in 2023. But I think the strength of the economy, everyone was expecting that the economy would start to go into more of a recession, there would start to be higher unemployment, there would be more of a drop in inflation, inflation would start to be more comfortable as the Fed would be more comfortable, that the inflation would be getting down closer to their 2% target rate. And so as we’ve come across hotter than expected inflation numbers, the market has pushed out the start of rate cuts. 

So, what does this mean for bonds? 

That’s the real question. Unless you’re trading Fed funds futures, what the Fed’s doing doesn’t affect you directly, but indirectly, what does that mean for bonds?  

And I think that in the higher-for-longer case, that really portends higher rates on the short end of the curve. And it’s been interesting to see whether… We haven’t seen too much of it yet, but if the rates stay up higher for longer, maybe that increases the probability that the Fed is going to engineer a recession. If that’s the case, then you should see maybe that the longer-term interest rates would fall on those recession worries. We haven’t seen that yet. Rates have been moving up across the board whether you’re looking at the short end of the curve or the long end of the curve. 

And so one of the things to keep an eye on is to see whether you do get a rally in the 10-year part of the Treasury curve, and whether that’s because of a rate-cutting cycle happening faster, or recession coming or the Fed actually breaking something. I think that the market has been very much in the idea that the Fed is going to engineer the soft landing or no landing scenario. And the fact that they have to leave rates higher for longer increases the probability of a harder landing than otherwise would be the case. 

Going forward, I think our outlook on fixed income, it’s been very constant over the past call it 12 to 18 months, and it’s really trying to play both sides of the market. We don’t know what’s going to happen with the economy. We don’t know if we’re going to get a recession in the latter half of 2024. We don’t know if we’re going to get a soft landing or a no landing scenario. So, really trying to put portfolios together that can do well in both scenarios. 

So in the no landing scenario, you want to have some credit risk, you want to have that yield pickup that you get, whether it’s from high-yield corporate bonds or emerging markets or structured credit where you’re getting a little bit extra yield there, but also wanting to have a big portion of your portfolio in your flight to safety, your flight to quality-type securities, whether it’s in longer-duration U.S. Treasuries or in agency mortgage-backed securities. 

So being able to put together a portfolio that can do well. Obviously in a recession, your flight to quality, your Treasuries, your agency mortgages are going to do well, but your spreads are going to widen out on your credit side of things. So you have to have that balance there. But if we do get a no landing scenario, then your agency mortgages and Treasuries are going to underperform, but your credit is going to do well. So 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, I think that that’s really the way to go and then really the way we’ve been positioning our portfolios so that in this time of the markets being very data-dependent, the Fed being very data-dependent, I think it makes sense to also be data-dependent and also try to position your portfolios to do well in either of those scenarios. 

Going forward, we like to say that at least there is yield in the market today versus in the recent past where there was not very much yield in the fixed-income market. I think that now you’re looking at places where there are opportunities across the fixed-income market. So being able to pick and choose where to take those opportunities, which sectors you want to overweight, which sectors you want to underweight is paramount.  

And so a lot of your corporate credit sectors are priced at very tight spreads, not historically tight spreads but getting close to those historically tight levels. And so maybe you want to underweight your investment-grade corporate bonds and your high yield just because those spreads are so tight and really at a place where they’re priced to perfection. You don’t have very much upside in terms of more spread tightening that can go on in those sectors. And you have a lot of downside. If we get a recession, spreads could widen out considerably from there. 

And really, try to focus more on, I would say your structured credit sectors, whether it’s commercial mortgage-backed securities, non-agency residential mortgage-backed securities, or asset-backed securities. Those types of sectors haven’t tightened in as much, so they have better risk-reward balance and really cases where there’s room for the spreads to tighten and really less room for spreads to widen because they haven’t tightened in as much. 

Specifically, I would say that we really like the commercial mortgage-backed security space out there. Spreads are still very wide. You don’t have to invest solely in what people think of when they think of CMBS’s office space and retail malls. You don’t have to invest solely in those sectors. You can invest in industrial spaces or hotels or even multifamily falls under that CMBS umbrella. So, there are opportunities to take good fundamental risks at wider spreads, which is always the goal there. 

Certainly, we also, on the no credit risk side of things, like the agency mortgage-backed security space. Spreads are still very wide. They’re not at the widest levels that they’ve been over the past 10 years, but they are pretty close to those wider levels. And so there are opportunities there. 

And a few years ago when you had to invest in the agency mortgage space, you were very limited in the coupons that you could buy in the agency mortgage space because everything was so low, rates were so low. Today, because rates are much higher you have a broad universe of coupons that you can invest in and you can pick and choose what kind of risks you want to take, what kind of rewards you want to take. So, something that is slightly below par but still in a refinanceable position, those are looking a little bit more attractive there because you do have that prepayment reward. If you do get lower rates and you get a refinancing wave, you can get those prepayment rewards. But if you are buying the very, very low, out of the money Fannie Mae one-and-a-half or two per cent coupons, those are not likely to be refinanceable any time soon. And so even though you would think that you would have much more prepayment reward because they’re much lower dollar price, that refinance ability is such a low probability event that it doesn’t really make sense to us to invest in those. 

So, given the current market environment, it’s not all of a place where we are not without risks. Certainly, if the Fed is staying at this higher for longer rate level, the risks of a recession are increased, maybe not considerably, at least in this point in time, but the probability of a recession has to be higher today than it was at the beginning of the year. 

And I also think that there are risks that people are chasing yield. People are really in a place where they are trying to take advantage of these higher rates overall, these higher yields, absolute yields that you’re getting in credit sectors. So, people are chasing that and that leaves the higher probability of you being less compensated for the default risk that may be in some of these securities. 

It doesn’t seem like that’s a 2024 problem, but more of a later half of 2025 problem in terms of when you could see defaults in corporate credit and high yield in bank loans.