Ken Leech
Chief Investment Officer
Western Asset
Inflation has proceeded faster and for longer than we antici- pated, and the damage to fixed income investments has been commensurate. However, we believe a falling-inflation scenario is still at play—one that would provide some comfort and respite to bond investors. In our analysis, bond yields are also now at very attractive levels—the 10-year US Treasury bond is at its highest rate since 2008. Given these factors and current market pricing, the priority for us over the next 12 months is to position portfolios to best maintain our current yield advantage relative to benchmarks. We see opportunities in specific places across fixed-income sectors.
The combination of higher rates, wider spreads and de minimis defaults makes a good case for owning IG credit, despite macro concerns. Fundamentals at the corporate level still appear very good to us, given issuers’ conservative approach to balance-sheet management.
Looking ahead, companies are going to face some challenges. Margins are likely to continue to feel the squeeze from elevated labor, financing and input costs. Corporates are already feeling the effects of significant wage increases, as evidenced by the first layoff announcements from various technology companies.
In the United States, corporate fundamentals may have peaked, but they are coming off a strong starting point. Concerns abound that earnings will decelerate given tighter financial conditions, rising input costs and the currency impact of a surging US dollar. We see opportunities in banking (where we expect further ratings upgrades), energy, select reopening industries (such as airlines, cruise lines and lodging), and rising-star candidates.
In Europe, utilities face higher funding needs, but with government support we see some opportunities in this space. Yields at multi-year highs look attractive to us. In particular, we like the three- to five-year part of the market. We find the most value in financials and real estate investment trusts (REITs) and are cautious on more cyclical consumer- facing sectors.
Additionally, we believe the quality of the HY market is the best it’s been in decades. Fallen angels downgraded from IG ratings during the COVID-19 pandemic put a significant amount of BB rated issues in the HY index. However, we continue to be extremely selective, choosing issues name by name. We also continue to favor IG energy.
In the United States, we believe HY credit spreads are relatively attractive. In our analysis, default rates are likely to rise from very low levels in the coming quarters, but yields are providing ample cushion for higher defaults. We continue to see opportunity in service-related sectors that are still recovering from the COVID-led recession and potential rising stars
In Europe, credit fundamentals face challenges including slowing regional growth, elevated energy prices, and tightening financial conditions. We see value in BB and B rated issues—focusing on more defensive industries, including telecommunications/cable and health care.
While we expect the homebuilding market is in for a major pullback as well as substantial home price declines, we see selective opportunities. Here are a couple of examples: For agency MBS, diminishing Fed and bank demand coupled with increased volatility remain headwinds, but we believe the fundamental picture has greatly improved as spreads have widened significantly and look attractive historically, while prepayment risk has subsided.
For non-agency commercial MBS (CMBS), fundamentals vary by sector, with continued strength in multi-family, industrial and lodging, but challenges remain in retail and office. Macro and rates pressures are depressing prices across the market; however, if volatility declines, we believe attractive yields are available across the capital stack for high-quality credits.
Whether you focus on demand and supply as the driver of prices, on interest rates, or on the money stock as a measure of Fed policy, we believe all of these indicators point to a substantial moderation of inflation in the near future. Furthermore, looking at economic conditions “on the ground,” pricing in the goods and housing sectors is already moderating
