Bond yields have been anything but boring in 2023. The Federal Reserve’s hiking campaign against stubborn inflation and resilient consumer spending, turmoil in Congress, and a bout of banking panic have kept fixed income analysts busy this year. But what does all this mean for advisors and longer-term investors?
VettaFi contributor Dan Mika spoke with Ben Lavine, chief investment officer at 3D/L Capital. The following interview has been edited for clarity and brevity.
How Advisors Should Think About Fixed Income
Dan Mika, VettaFi: There are so many things happening with bonds right now. There’s what’s happening at the Fed. with it signaling higher rates for longer and the resulting steepening on the long end of the market. Also, inflation is still sticking above its 2% target. At the same time, consumer spending and the job market continue to run hot. However, there are questions around how long that can be sustained. For an advisor, what do you think are the biggest priorities within this picture to figure out what would fit their clients best?
Ben Lavine, 3D/L Financial: Ultimately, fixed income serves two roles within an advisor’s investment program: income and risk control. It basically serves as the ballast in a balanced portfolio consisting of risk-on assets such as equities and commodities. Fixed income and duration in particular historically have served as the volatility dampener in that balanced portfolio. The challenge that advisors face today is the playbook for the next 10 years. Will it look like the playbook we’ve all been used to for the last several decades?
In the early ‘80s, when interest rates were at double-digit levels, we basically had a three-decade bull market in bonds. Rates were going all the way to zero on the short end and less than 2% on the long end during the height of the pandemic. Over the last few years, with fits and starts, we’ve been seeing an adjustment to that playbook. Advisors and their clients have to get used this idea that we’re in a different regime. It’s characterized perhaps by higher inflation expectations, or at least higher nominal rates that can support an economy [so that it can] operate at its full capacity without sparking additional inflation.
Higher Rates Becoming Normalized
What’s fundamentally changed over this past year — apart from the Fed aggressively hiking rates from 0% to 5.5% — is this idea that structurally, nominal interest rates can be higher. We can afford to run higher interest rates to support a normal-running economy without inducing a major recession or major contraction in economic activity. That has implications: Higher interest rates mean higher borrowing costs for everyone. It could also mean tighter lending conditions.
Credit’s not as available with a higher risk-free rate. That higher rate makes it a lot more competitive in attracting people’s savings and in terms of making long-term capital budget decisions on the part of corporations. There are implications not just for savers and investors, but for borrowers as well. Advisors need to rethink how they’re deploying fixed income within their program. Perhaps they could be more mindful of matching the duration of liabilities of their clients’ liabilities with that of the underlying assets. That’s instead of just mechanically relying on the intermediate benchmarks that we’re all used to seeing in a typical 60/40 portfolio.
That might mean having to do more bond laddering. That also means having to be more mindful of the kinds of risks you’re taking up and down the fixed income term structure. It might mean exploring other sources of risk diversification in the fixed income marketplace. It’s become a lot more complex exercise for advisors having to navigate the fixed income landscape from what they were used to over the last several decades.
Defensive on Credit?
VettaFi: Several times in that answer you mentioned risks, particularly at the macro level. In your latest note, you’re suggesting advisors working with clients across all time horizons should favor investment-grade asset-backed maturities and mortgage-backed securities, and be relatively defensive on credit risk. Would you explain why?
Lavine: Partly valuation. Take a look at the yield spreads above comparable risk-free Treasuries and the structured financial space of investment-grade (asset-backed securities) such as auto loans, credit card receivables, and mortgage-backed securities. They’re trading at historically wide levels.
Some of that is due to the inherent interest rate volatility. It means the convexity profile of a lot of these securities isn’t as attractive when there’s a lot more uncertainty embedded in the forward interest rates. However, it’s also because there are concerns about liquidity, credit risk with the commercial office space, and so forth. But what you find relative to just straight corporate cash-pay bonds, the structured product space is as attractive as it has been historically.
Investment Grade & High Yield Fixed Income
If you’re going to figure out your best investment-grade bang for the dollar, the structured products base offers more attractive spreads. That’s not to say corporate cash pay doesn’t look attractive. Fundamentally, corporate balance sheets haven’t been this strong. Coming out of the pandemic, they took advantage of low rates to term out their debt or to refinance.
A lot of high-yield issuers are facing a very strong demand environment for yield. As long as the overall economic backdrop remains positive, then the borrower window for even high-yield companies is open. That suggests there are a lot of opportunities right now to invest across fixed income. But at the margin, one could argue that the structured sectors within the fixed ncome marketplace look marginally more attractive.
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