So just a quick summary, you would be a little hesitant entering duration in the short term, but it’s a good time to move into fixed income and especially in some of the spread type products?
Sonal: I’d say that’s fair, but on the other hand, I’m not saying don’t go into duration at all because certainly if you just want to put something somewhere and forget about it, you’re getting better returns right now than you have in a long time. I would note that short duration Treasuries in some ways are giving you better returns than anything on the long end given the inversion of the yield curve, which I don’t think is justified.
Francis, there’s a lot of uncertainty and a lot of competing forces. Given that, where are you seeing opportunities in duration right now?
Francis: I think, generally speaking, it’s pretty constructive for adding duration. The problem is that the long end of the yield curve is held in check to some extent by the Fed’s stubbornness at the short end of the curve—especially given how steeply inverted the curve is right now. Fed policy historically is notoriously schizophrenic, it goes from tightening to easing, often without a lot of transition—this Fed in particular has this characteristic. So, I do think there’s going to be another, as I said, “oh my God” moment at the Fed, much like there was last year when they pivoted from maximum stimulus to hitting the brakes. I think that moment will come this year, but it may take a labor market dislocation. And clearly, as that arrives, that will be a big plus for fixed income when it happens.
Mark, let’s turn to you and Western Asset’s view of duration.
Mark: There are risks to the growth question, just given where we are in the economic cycle and what central banks are trying to engineer. That causes us to believe that duration, which has been a benefit for this bull market over the decades, and which worked miserably in 2022, will work better in 2023. Therefore, we do want some duration. I think to Sonal’s point, you can be tactical about that. Remembering, for example, June into July of 2022, we saw a vicious rally in the market where 10-year Treasury notes came off by 90 bps, moving from around 3.5% on June 14 to around 2.7% on July 29.9 That turned out to be a really good selling opportunity. But we think it is different now from an economic, monetary policy, and most importantly, an inflation point of view. Perhaps the market has moved a little too quick. It’s important to remember that in fixed income, it’s all about yield. We haven’t seen these yields in Treasuries and investment-grade corporate bonds in 20 years. The pie is getting bigger. I think the people are allocating to fixed income away from other sectors just given the expected risk-adjusted returns.
So, from a duration point of view, we think it pays to be long. One of the things that we like to look at is the consensus of the market—where the forwards are. Where is the one-year forward, where is the Treasury curve? And if you look at twos through 10s, the answer as of now is about 3.3%. It’s substantially lower on the short end of the yield curve and only a little lower in 10-year Treasury notes. We think that’s about right, and the bigger discussion we have from a macro point of view is more on the yield curve than it is on the overall duration, but we do want to hold duration against some of our favorite spread sectors or our risk sectors in a broadbased portfolio.
What risk-spread sectors have opportunity?
Mark: Given the uncertainty over growth and the valuations we now see, I think many investors are surprised at where investment-grade corporates, high-yield bank loans, emerging markets structure, munis, etc. are currently trading. They’ve done very well at the start of the year. What we have tended to do is to increase the investment-grade sectors, investment-grade corporates—for example, Treasury plus a spread—but the absolute yield is pretty darn attractive. We feel that that is a good place to be. We don’t dislike high yield and bank loans, but we want to be a little more careful there from a quality point of view. On the structured side, we favor mostly shorter durations going up the capital structure. We find AAA non-residential, commercial real estate asset-backed securities very attractive. Given the uncertainty surrounding what’s happening with residential areas of the housing market, and commercial real estate in particular, we need to differentiate between what’s happening in the office and industrial sectors. And then finally emerging markets, as Michael has pointed out, we see some very, very attractive opportunities there.
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Gene, what are your thoughts on duration and also for investors looking at moving from equity into fixed income?
Gene: In terms of fixed income duration, right now we’re just a touch longer than our benchmarks, but not by much. We are not looking to go long duration today, and we’re also fairly concerned about the shorter side as well given the trajectory of interest rates going forward within fixed income. We are carefully looking at the shape of the yield curve. We are also cautious on floating-rate loans (bank loans), that’s not somewhere that we’re concentrating on right now, or high yield. High yield is interesting because it looks like the longer-term implications are quite favorable, but we’re very concerned with the short-term and volatility over the next six to 12 months. So, we’re relatively negative on high yield over that shorter horizon. Elsewhere, we’ve become less constructive on Japan and China. But the overall story for us is relatively duration-neutral, we’re certainly interested in the higher yields coming off of Treasuries, looking at investment-grade favorably, and skeptical right now of some of the higher-spread sectors.
“ In terms of asset allocation, I think it really comes down to one’s time horizon. Right now, crafting a durable portfolio with a five- or 10-year time horizon requires a different mix than if you’re looking to be more tactical, in our view.” Gene Podkaminer
In terms of asset allocation, I think it really comes down to one’s time horizon. Right now, crafting a durable portfolio with a five- or 10-year time horizon requires a different mix than if you’re looking to be more tactical, in our view. The former may see a healthy allocation toward risky assets, while the latter may lighten up on equity exposure in order to fund investment-grade fixed income. Let me start with the longer term first—high yield and equity have characteristics that are very similar in the long term. High yield has probably the most exposure to economic growth of any fixed income sector out there. One can argue that high yield is as close as you get to an equity substitute within fixed income. Over the long-term, we see a very robust return for high yield compared to investment-grade bonds and cash. But over the shorter term, if an investor is worried about recession and wants to meaningfully reduce their exposure to the economic growth factor, or avoid volatility, high yield is probably not where they should be looking. Generally, the relative safety of sovereigns and investment-grade bonds would better align with their concerns. So perhaps for right now, bypassing some of those higher-spread segments in the interim, as volatility passes.
