The bond market may have limped through a lousy 2022 only to be hit with a banking crisis earlier this year, but some fixed-income portfolio managers are seeing sunny days ahead for the rest of 2023, whether there’s a recession or not.
Los Angeles-based Capital Group’s fixed-income portfolio managers Shannon Ward and Damien McCann had nothing but positive things to say yesterday about the prospects of the asset class as they discussed current credit and core bond opportunities in a webinar.
“Big picture: bonds are back. We’ve gone from yield-starved just 16 months ago to an abundance of yield opportunities,” McCann said. And investors are now at a point where, over a multiyear period, it’s become mathematically difficult to generate a negative total return in bonds given the starting point for yields.”
For example, with investment grade corporate bonds currently at a starting yield of 5%, investors over a two-year period will have 10% total return coming from the yield.
“You would need a very significant move higher in the yields to offset all of that income you’re generating,” he said. “In the short term, you can experience a negative total return, but we’re long-term investors.”
Another interesting development in fixed-income investing, Ward added, is that investors can earn a good return from high-yield bonds (that are trading at discounts) when they return to par as they get closer to maturity or as the underlying rate market changes.
“In this environment, when high yield is yielding 8.5% or 9% and the average high-yield bond priced in the high 80s, you just have to look at the case for the likely returns being really good,” she said. “And the chances are really good if you have a reasonable time horizon.”
Both portfolio managers said they thought the Fed was close to being done with hiking interest rates, and is just waiting for inflation data to show that they can stop.
“The Fed is trying to slow economic growth by hiking rates as they have. That seems to be happening but not nearly as quickly as the Fed and markets have expected,” McCann said, adding that he expects another hike in May, and then potentially one more following.
McCann said one area he focuses on is investment-grade credit and the opportunities worth highlighting are the utility sector, and in particular California utilities, where he’s seeing 6% yield for issuers that are hardening distribution systems against wildfire risk. Also, he said, aerospace, which is currently offering 5% to 5.5% yields and where demand is locked in for the next several years, and pharmaceuticals.
Meanwhile, Ward looks at the high-yield market and assesses ratings, not sectors.
“The majority of the high-yield market is not what people think of—risky companies that are barely making ends meet. There are actually a lot of good companies double-B rated, publicly listed, reasonably levered, and those are yielding 7%,” she said. “The overall market is close to 9%, but you can be carefully positioned in high yield and earn 7%.”
Ward said she’s building her portfolio around higher quality companies that do well against a rougher macro backdrop and could have some tailwind if yields fall. “Total returns could even outpace the 7% we’re looking at now,” she said.
When pressed for some sector options, Ward named gaming, consumer non-cyclicals, and healthcare, although BB companies can be found in every sector, she said, as currently more than 50% of high-yield offerings are rated BB.
Private credit, however, is a different story, she said. Over time, this sector has become a haven for companies (mostly leveraged buyouts) that don’t want to deal with the pace and scrutiny of the public high-yield market.
“Risks get embedded that you wouldn’t like to see,” Ward said. “The way the private credit market has grown, it’s even bigger than the high-yield market now—$1.4 trillion is the last number I saw, and that’s probably even out of date.”
Whenever there’s a lot of money flowing into an asset class, “the seeds of future problems are planted,” she said.
“That risk-taking behavior that used to get vetted in the high-yield market is now being done away with in private credit,” she said. “I worry about the private credit market being the next bubble, and so I’m being very cautious. Lending based on recurring revenues for companies that don’t have free cash flow? I don’t see how that ends well, and so I’m just a pass.”
Otherwise, both Ward and McCann said they see the fixed-income asset class as being very healthy, even if the U.S. does enter a recession.
“I would encourage investors to extend out on that yield curve. History tells us that once the Fed stops hiking, and we seem to be nearing that point, longer yields aren’t likely to rise much and historically have tended to be lower over the few years following peak Fed funds,” McCann said. “By taking a bit more duration or interest rate risk as we approach peak Fed funds, your total returns going forward can be even better than the starting yield.”