Boston - As both the US and broader global financial markets experience sharp turns, a sense of unease prevails around the future path of the markets, as well as the coronavirus. In the face of seemingly contradictory economic data, the market rebound took many by surprise, as did the deep dip that followed. In all this, we'll look to address a common question: What are the best moves for fixed-income investors now and what areas have staying power?
Opportunities in corporates
As investors who look across the full spectrum of fixed-income investments available to our strategies, despite all that has happened, we still see areas of value. First, in looking at the broad market, we find renewed interest in taxable, investment-grade (IG) corporate fixed income, which we believe offers attractive valuations, strong liquidity and supportive technical market conditions. Corporate credit spreads are wide, and in our opinion, compensate investors for future fundamental and economic uncertainty.
In assessing the post-COVID-19 future, unavoidably there will be increased dispersion of IG returns between companies that survived or thrived during the pandemic and those that struggled or failed, making a strong argument for the value of active management. Over time, IG corporates have historically been shown to provide a stable, risk-adjusted return relative to the low risk of issuer default. Over the past 10 years ended March 31, 2020, IG corporates have returned 4.92%, as measured by Bloomberg Barclays US Corporate Bond Index, compared to 3.88% for the Bloomberg Barclays US Aggregate Bond Index. The historical average rate of IG issuer defaults ranges from 0% for AAA rated bonds to 0.16% for BBB, versus 0.61% for BB rated and 3.33% for B, for example.1
Hedge-adjusted yields also offer an attractive opportunity for overseas investors that hedge currency risk. Further IG support comes from the Fed's continued direct purchase of short-to-intermediate-term (5 years or less), BBB-rated corporates as a price-insensitive buyer. Specific areas we like within IG corporates include money center banks with strong balance sheets, and technology and telecom companies, some of which have a strong connection to the growing remote workforce.
Why securitized may shine
Unlike IG corporates, the securitized credit sector has been slower to recover in the second quarter. We see two reasons for this: First, concerns over consumer strength grew during the shutdown, calling the fundamentals of these bonds into question. Second, unlike other fixed-income sectors, there hasn't been direct buying of securitized assets by the Fed, although the Term Asset-Backed Securities Loan Facility (TALF) program that is starting up should be supportive.
Securitized issues were roundly criticized as being surprisingly risky after the global financial crisis. While this reputation serves to raise yields, in fact, many deal structures were significantly strengthened after the 2008 crisis, both in terms of stronger underwriting requirements for borrowers and increasing the amount of collateral supporting deals. Even under some of the "extreme consumer stress" economic scenarios, we believe this sector is attractive for long-term investors, particularly in the senior tranches. Credit-risk transfer bonds, which hold Fannie Mae- and Freddie Mac-approved mortgages, and commercial mortgage-backed securities, both agency and non-agency, continue to show value, in our analysis.
What do we like less? US Treasurys and US agency bonds will always have a role to play as "ballast" in any investor's portfolio. But the return to extremely low levels of interest rates will mean that large defensive allocations will have a material drag on an overall portfolio's yield. Also, the potential for a steeper yield curve in the face of rising deficits cannot be dismissed.
Bottom Line: With financial markets volatile once again and the intermediate economic picture uncertain, we believe select IG corporates and securitized bonds are attractive on a risk-adjusted basis, and are pursuing these strategies in our portfolios.