Why Investors Should Feel Good About Fixed Income
Oct 16, 2024
PGIM Fixed Income explains that ingredients for favorable fixed income returns remain in place, with potential for rangebound rates to decline from current levels over time.
Amid bullish bond conditions underpinned by strong yields and narrowing spreads, investors await market momentum courtesy of a shift toward lower yields following peak rates. Yet bund and Treasury yields remain near the same levels they occupied roughly two years ago at the bull market’s outset. Still, even if rates and spreads remain rangebound in the near term as we expect, fixed income should continue to deliver solid returns.
Lingering yield curve inversion shows that a notable amount of investor optimism regarding economic moderation and rate cuts is already factored into long-term yields, potentially limiting their capacity for imminent decline. It is reasonable to expect long rates to consolidate around current levels until visibility improves regarding terminal rates for central bank rate-cutting cycles in developed markets. With monetary policy weighing on short rates, conditions are in place for the yield curve to continue to steepen.
While this is largely in line with our previous views, we now see added impetus for falling rates to boost returns on an intermediate-to-longer-term basis. Economic softening is in progress and cutting cycles are underway in earnest. Already strong, bond fund inflows should strengthen amid an intensifying search for yield as cash returns lose their previous allure. This shift should exert downward pressure on yields and contribute to opportunities to benefit in a falling-rate environment.
Cautious Optimism for IG Corporates
U.S and European investment grade (IG) corporate yields have retreated from year-to-date peaks as investors anticipate more easing on the monetary policy front. Demand should remain consistent, but lower yields, tight spreads and heavy issuance represent potentially limiting forces. Amid expectations for softening economic conditions, we are modestly constructive on the sector in the near term while remaining mindful of downside risks.
In the U.S., trends in corporate revenue and profits remain positive, though credit metrics reveal pressure from rising interest expenses. Upgrades decidedly outpace downgrades at this point in the year, suggesting continued resilience. With previous forecasts for 2024 gross issuance already surpassed, the full-year tally could come in as much as one-third higher than initially expected. So far, market absorption remains strong amid demand driven by overseas investors and mutual fund flows.
Five- and 10-year swap spreads on the European IG curve have been elevated since the invasion of Ukraine and the emergence of related economic challenges. As investors have become more comfortable with risk, swap spreads have compressed, bringing them back in line with historical levels. Still, spreads remain near the lower end of the historical range, warranting caution. Yields remain enticing, but the spread component is decidedly less attractive.
Will Defaults Hinder High Yield?
Stable fundamentals and greatly reduced recession odds should keep spreads rangebound and demand for new high-yield issuance robust. A focus on high-quality issues with a bias toward short duration still makes sense amid elevated geopolitical risk, while careful credit selection with an emphasis on relative value opportunities appears to be the most promising path for pursuing outperformance.
At current levels, further spread tightening in the U.S. poses limited risk. Solid corporate balance sheets underpin a U.S. high yield market that boasts historically high levels of credit quality. Our base case forecasts a decline in defaults in the coming year and, even the economy falls short of expectations, we believe any associated uptick would be manageable. Credit selection driven by extensive credit research that steers clear of defaults should be a big alpha driver in the next 12 to 24 months.
Barring unforeseen shocks, European high yield spreads should be rangebound in the short term. We expect yields to remain attractive. Defaults should hover near current levels in a European market landscape mainly consisting of high-quality businesses. While the range varies among different probability-adjusted economic scenarios, we expect high yield bonds and loans to generate positive excess returns.
Standout Growth in Emerging Markets
Like other sectors, the emerging market debt (EMD) landscape deserves a constructive yet cautious outlook, but in this instance geopolitical factors and U.S. policy dynamics play a more influential role. Performance dispersion across and within EMD sectors continues to unveil alpha opportunities, underscoring the sector’s complexity.
Spreads among hard-currency sovereigns are expected to remain stable amid ongoing crosscurrents. While geopolitical uncertainties persist, particularly concerning risks related to U.S. trade policy, EMs still seem likely to benefit from anticipated developed economy rate cuts and a favorable macroeconomic backdrop. The EM growth premium versus the rest of the world could expand in the intermediate term as fiscal concerns and other constraints weigh on developed markets.
We still see the best value in EM corporate BBs and select longer-dated BBB issuers. We also continue to favor exposure to EM duration, though not as much as we did prior to recent rallies. Top-down factors are likely to remain key influences in the near term, potentially driving tactical opportunities until the landscape can be reassessed following the outcome of the U.S. election.
Active Potential to Outperform
With the bond market backdrop notable for solid balance sheet trends among issuers, macro uncertainty appears to pose the most pronounced near-term risk. Geopolitical tensions and economic datapoints that depart from consensus thinking represent potential sources of market volatility, which would likely create more relative value opportunities in an already fruitful environment for active managers. At PGIM Fixed Income, we see an encouraging outlook for investors who focus on fundamentals and enjoy the flexibility to adjust as conditions shift.
References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The securities referenced may or may not be held in the portfolio at the time of publication and, if such securities are held, no representation is being made that such securities will continue to be held.
The views expressed herein are those of PGIM investment professionals at the time the comments were made, may not be reflective of their current opinions, and are subject to change without notice. Neither the information contained herein nor any opinion expressed shall be construed to constitute investment advice or an offer to sell or a solicitation to buy any securities mentioned herein. Neither PFI, its affiliates, nor their licensed sales professionals render tax or legal advice. Clients should consult with their attorney, accountant, and/or tax professional for advice concerning their particular situation. Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. The manager has no obligation to update any or all such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy.
Any projections or forecasts presented herein are subject to change without notice. Actual data will vary and may not be reflected here. Projections and forecasts are subject to high levels of uncertainty. Accordingly, any projections or forecasts should be viewed as merely representative of a broad range of possible outcomes. Projections or forecasts are estimated based on assumptions, subject to significant revision, and may change materially as economic and market conditions change.
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