Rising recession risks following rapid Federal Reserve tightening reinforce the appeal of owning high-quality bonds, according to fixed-income investing giant Pacific Investment Management Co.

Pimco, which oversees roughly $1.7 trillion in assets, warned in a new report Tuesday that recent banking failures and a rising cost of capital are increasing “the prospect of a significant tightening of credit conditions, particularly in the US — and therefore the risk of a sooner and deeper recession.”

The bond manager’s thrice-yearly cyclical outlook report, titled ‘Fractured Markets, Strong Bonds,’ argued that while the end of central bank interest-rate increases is near, “not tightening further is different than normalizing or even easing policy, which will likely require inflation falling toward target levels.”

In the current environment, “bonds appear poised to exhibit more of their traditional qualities of diversification and capital preservation, with the potential for upside price performance in the event of further economic deterioration,” Tiffany Wilding, the firm’s North America economist, and Andrew Balls, its chief investment officer for global fixed income, wrote in the report.

Bonds have rebounded this year after suffering double-digit losses in 2022, with the Bloomberg US Aggregate Index up 3.4% so far in 2023. The 10-year Treasury yield swung between a low of 3.28% and a peak of 4.09% in March alone amid the biggest surge in Treasury market volatility since 2008.

The investment implications include:

• 10-year Treasury yield is set to trade within a “range of about 3.25% to 4.25%,” with the possibility “to shift the range lower given increased risks.”
• Although short-term, cash-equivalent investments provide “relatively elevated yields” and have “potentially less volatility than many other investments,” but this sector “won’t provide the same diversification properties and ability to generate total return through price appreciation if yields fall further, as has occurred in prior recessions.”
• Stress among banks “reinforces our cautious approach toward corporate credit, particularly lower-rated areas such as senior secured bank loans,” and Pimco retains “a preference for structured, securitized products backed by collateral assets.”
• US agency mortgage backed securities “remain attractive, particularly after spreads have widened lately.”
• Broad-based selloff in the financial sector “has made some senior issues from stronger banks look more attractive,” and Pimco favors “senior debt over subordinated issues.”
• In private markets, “prices of existing assets have been slower to adjust compared with public markets,” and Pimco has been “prioritizing liquidity more than usual across our strategies and are prepared to take advantage of market opportunities and dislocations that arise.”
• In commercial real estate, “senior parts of the capital structure in diversified deals” are favored and investors should “avoid lower-quality, single-asset or mezzanine-level risk.”

This article was provided by Bloomberg News.