The Macro Picture and Market Implications
Daleep Singh, Chief Global Economist at PGIM Fixed Income, looks forward to the Fed reversing course on interest rates as part of his global economic outlook.
Positive Catalysts Create Relative Value in Fixed Income
Dec 6, 2022
PGIM Fixed Income’s senior portfolio manager, Michael Collins, CFA, explains why bond ballast comes back and how to prepare for evolving conditions.
BOND BALLAST COMES BACK
Bond markets endured one of their worst years in history, resulting in an anomalous period in which bonds were less effective insultation to investors seeking equity-risk mitigation. With that said, the current configuration—where spreads have widened and yields on government bonds have risen—is hardly the norm. In most cycles, when spreads are wide, there is an economic slowdown and/or financial crisis, which drives government bond yields lower. Conversely, when the economy performs well and government yields are at their cycle peaks, spreads are often tight. This opens the possibility that once the fear of the central bank rate hikes passes, the bond market will present a rare opportunity of both peaking yields and spreads. While risk assets may experience more volatility in the short-term, significant value has been created for the long-term investor. The renaissance of higher yields restores the balance to the asset allocation mix and should be warmly welcomed by investors and savers.
Credit quality is high and should enable corporations to better weather an economic downturn without raising default rates.
PREP PORTFOLIOS FOR EVOLVING CONDITIONS
The sell-off in bonds in 2022 combined with higher yields have created tremendous value opportunities in fixed income markets. If our thesis is accurate—peak rates in early 2023, followed by a pause for a few months as data comes in confirming economic slowing and wage pressure cooling, culminating with precautionary cuts in the second half to avoid a deep recession—investors would do well to build up their bond exposure based on the shifting environment. Playing the short end of the curve may be beneficial approaching the peak, while adding credit exposure may help boost total returns if the Fed pauses. Adding to risk assets like high yield and emerging market debt may be beneficial once the Fed begins cutting and the U.S. dollar softens—or in the event that the Fed is successful in engineering a soft landing. The timing of when each of these may be attractive varies, requiring strong analysis and security selection.
Michael J. Collins, CFA
Senior Portfolio Manager
PGIM Fixed Income
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Risks—Investing involves risks. Some investments are riskier than others. The investment return and principal value will fluctuate, and shares, when sold, may be worth more or less than the original cost. Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, and political and economic uncertainties. Investing in emerging markets is very risky due to the additional political, economic, and currency risks associated with these underdeveloped geographic areas. Investments in growth stocks may be especially volatile. Value investing involves the risk that undervalued securities may not appreciate as anticipated. It may take a substantial period of time to realize a gain on an investment in a small or midsized company, if any gain is realized at all. Real estate investment trusts (REITs) may not be suitable for all investors. There is no guarantee a REIT will pay distributions given the inherent risks associated with the market. A REIT may fail to qualify as a REIT as defined in the Tax Code, which could affect operations and negatively impact the ability to make distributions. There is no guarantee a REIT’s investment objectives will be achieved. Diversification and asset allocation do not guarantee profit or protect against loss. Investments in in Master Limited Partnerships (MLP) and MLP-related investments are subject to complicated and in some cases unsettled accounting, tax, and valuation issues, as well as risks related to limited control and limited rights to vote, potential conflicts of interest, cash flow, dilution, and limited liquidity and risks related to the general partner’s right to force sales at undesirable times or prices. MLPs are also subject to risks relating to their complex tax structure, including losing its tax status as a partnership, resulting in a reduction in the value of the MLP investment. Many MLP investments are in the energy sector and subject to a greater degree to risk of loss as a result of adverse economic, business, regulatory, environmental, or other developments affecting industries within that sector than investments more diversified across different industries. Diversification and asset allocation do not guarantee profit or protect against loss.
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