Fixed-Income Opportunities in a Lower-Rate Environment

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Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves.  

Jeff Mayberry, portfolio manager at DoubleLine Capital.  

We’re at a pretty interesting time in terms of what the Federal Reserve is thinking or doing, and we’re at an inflection point now where, assuming that inflation is continuing its current trajectory, the Fed is changing its outlook from worried about inflation to worried about growth. And so, they’re starting to signal the, well, they certainly signal the end of the hiking cycle. And they’re starting to signal the fact that interest rate cuts will be imminent, coming up possibly at their next meeting on September 18. And it’ll be interesting to see whether they follow through with that, and obviously it’s going to depend on how the data shakes out before the meeting.  

There’s certainly inflation and growth numbers that they’re going to receive, but it’s a market shift from being worried about inflation to being worried about growth. 

And so, the way this kind of affects things, though, is that for a long time we’ve heard most people are staying and buying a lot of treasury bills, the low duration, kind of no risk asset, because it is yielding so much, especially compared to other parts of the curve, with the U.S. Treasury curve being so inverted. So, when the Fed starts cutting rates, whether it is in September or October or later on this year, certainly we’ve seen the high in T-bill rates, and so it’s actually a very good time for investors to start thinking about or actually moving into alternative fixed-income investments to treasury bills.  

We can lock in fixed rates today, you can lock in spreads today that are higher than T-bill spreads. And though you’re taking on a little bit more, either credit risk or duration risk, at least you’re being compensated for today, and you can kind of lock in these higher rates and these higher yield levels versus where T bills are.  

You’ve certainly seen the high in T-bill rates. The market has priced in anywhere from four to five rate cuts to the end of 2024, if you look out past 2024 to 2025, the markets pricing in even more aggressive cuts. Looking at, you know, as of mid-August, about a couple hundred basis points in Fed cuts. And so being able to lock in rates, lock in these yields today, is a very attractive time.  

If you wait until the Fed starts cutting, the markets are going to have already reacted to a lot of the data points that are coming out and pricing in higher probabilities of rate cuts. And so, it makes sense to kind of move into different fixed-income markets before the Fed starts cutting.  

You’re at a place now where yields and spreads are priced kind of in agreement with the Fed, with no recession on the horizon, and being able to take advantage of those spread levels today makes sense. Now, the idea behind kind of locking in these, I wouldn’t say they’re priced to perfection, but they’re priced somewhere close to perfection, and something like U.S. corporate high yield, but there are opportunities in other sectors of the market, whether it’s in structured products, agency mortgage backed securities, commercial mortgage backed securities, there are ample opportunities out there for picking up spread product, picking up extra yield, without taking on too much extra risk.  

With inflation having come off its highs, but still remaining at higher levels than you’ve seen over the recent past, or, I guess, semi-recent past, it really is a case of people are in a different mindset today. So back, pre-Covid, no one was worried about inflation. Now, people have lived through some inflation and seen the pain of inflation, and so I think that people are a little bit more uncomfortable with having inflation put in the back of your mind. And so, they’re a little bit more worried about inflation, and they’ve seen how inflation can eat away at your kind of real return in the fixed-income market. And so, by and large, you would expect that all else being equal, interest rates would be, interest rates and yields on the fixed income would be at higher absolute levels to account for that possibility of inflation staying higher than historically has been, maybe even higher than the Fed’s expectation of getting back to a 2% inflation target.  

If we settle in at 2.5%, would the Fed be okay with that? I would think that they’d be happy as long as the trajectory is going down, but I think that leads to higher yields overall.  

There are ample opportunities out there in the fixed-income market today for investors that have a broad investing universe, something like the commercial mortgage-backed securities market is, our team likes to say that it’s priced for depression, I would say that is probably not priced to depression, but, you know, a mild recession. Spreads are already being priced into that market. So, if we do get a mild recession, then you would expect that that type of market, the yields and the spreads, would not widen out as much as something that is priced to perfection, something like U.S. corporate high yield, which is priced to really a no-recession scenario. So, if you had a sample set of two credit sectors, you would probably prefer to be in the commercial mortgage backed securities sector versus the high yield sector, just because it is priced to a more downward scenario.  

Now that’s not say it’s not without risk, and certainly there’s a lot of headline risk in the commercial mortgage backed securities market. But if you stay up in the higher credit classes that are collateral that mitigates a lot of that headline risk that you could see in the commercial mortgage backed securities sector overall.  

Something like agency mortgages is actually another very attractive sector treatment, historically wide spreads, or at least post-financial crisis wide spreads, and really at a place where you can get some credit risk free yield or yield advantage over treasuries. And so, that’s something that we’ve really been liking over the past year and a half or so, and really something that we think offers a lot of value.  

If you compare your credit risk side with your non-credit risk, you can build a better portfolio, so something that has a lower duration than your benchmark, something that is a little bit more credit risk, more yield, but really is in a place where, if the U.S. hits a recession, the non-credit risk agency mortgages or treasuries portion of your portfolio will do well, and you can use that as your dry powder to buy credit side of things that have widened out.  

And something that CMBS, where already spreads are already at relative wides should widen out less, and so you can take advantage of those opportunities there. So, it’s really a good time to be a fixed-income investor, certainly compared to where we were pre-Covid, where yields were such low absolute levels, at least here you’re getting some yield, and there’s going to be some opportunities to pick up extra yield if the U.S. gets into recession. If we don’t go into recession, then you have that extra yield, and you’re clipping that extra coupon. And so, putting together a portfolio that can take advantage of both different scenarios, that really is, is a good opportunity for investors out there. 

One of the things that we’ve been thinking about and contemplating in risk for the longer term, not necessarily in the next 12 months or so, but over the next two or three years, is that the budget deficit in the U.S. is at very high levels. Some would say, historically high levels, and really at a place where, if the U.S. does get into a recession, we would expect more fiscal support from Congress, and that would expand the budget deficit even larger than it is today.  

And by itself, that’s not terribly worrisome. The U.S. economy is still growing very fast. And so, when you can kind of compare the budget size to the economy, it doesn’t look terribly out of line. But if we get a recession, then you would expect the economy to contract some, the budget deficit to widen, and that makes your deficit to GDP number explode higher. And at some point, we don’t know when, but we believe that at some point, the so-called bond vigilantes will come into play again and that they’re going to need higher yields in the U.S. on Treasurys than they have historically needed, because they’re going to need to be compensated for that risk of more and more issuance of Treasurys.  

One of the things that we are concerned about is that if we get a recession, you could see the Pavlovian response of flight to quality, buy Treasurys, you want to buy long-duration treasuries and have those, because those are the ones that are going to go up the most if we get a rally in yields, so you want to buy those. But at some point, those are the ones that are also most exposed to this ballooning budget deficit. So, you could see a rally in interest rates, long-term interest rates, in a recession, the fiscal response being very large. The Congress learned that they do a large fiscal response, it worked in Covid, it’s going to work in the next recession. And then you could actually see long-term yields rise from there as the bond vigilantes get worried about the budget. And in that case, you may have a short-lived positive response from bonds and then a negative response after that.  

So, that is more of a longer-term risk. Certainly, it’s independent of whichever party wins the presidency or Congress. Both sides would elect to have a ballooning budget deficit, so that’s something that we are concerned about over the long term.