As global markets respond to interest-rate changes and shocks in the banking sector, we gathered a panel of fixed income investment leaders to discuss investment opportunities and trends in the global fixed income markets.
Our panel discussion was moderated by Catherine Matthews, Global Product Specialist, Western Asset, and included Tracy Chen, Portfolio Manager, Brandywine Global; Jennifer Johnston, Director of Research, Franklin Templeton Municipal Bonds; and Annabel Rudebeck, Head of Non-US Credit, Western Asset.
Below are my key takeaways from their discussion:
Uncertainty is especially high surrounding the next possible Federal Reserve (Fed) move. The markets continue to be unsettled as the central banks seek to balance the risks of inflation with the risks of unanticipated economic shocks. They also have the unenviable task of continuing to estimate the size of the lag between rate hikes and economic impact.
On March 22, the Fed raised rates by 25 basis points and amended its post- meeting policy statement. The statement said, “The committee anticipates that some additional policy firming may be appropriate.” The statement no longer contains the phrase that “ongoing increases” in rates would be appropriate.1
The European Central Bank (ECB) raised rates 50 basis points on March 16. We are waiting to see what action is taken by the Bank of England going forward. The guidance from the central banks will provide a signal as to how rates will be adjusted to balance inflation control and economic shocks going forward.
Bonds are staging a comeback year. After posting one of their worst years in 2022, yields have become very attractive relative to both the recent rate environment and the long-term yield history. Notably, municipal bonds offer a tax-free income stream, making their yields particularly attractive for taxable investors.
Today’s banking shocks are not the same as the global financial crisis (GFC). This is not a full-blown, systemic banking crisis. The regulations put in place after 2008 mandated much better strength in banking capital holdings. As a result, we are not seeing weakness on the asset side of the banking structure. Portfolio loans have particularly strong underwriting characteristics. There are also years of home price appreciation that can cushion performance of the mortgage loan portfolio.
A mismatch of duration (short-term client deposits vs. long-term assets, often in Treasuries) tied to changes in interest rates has driven the current banking stress. This will be addressed as banks move to tighten their lending standards and seek to improve their duration and interest rate mismatch.
Structured credit has better fundamentals than during GFC. The poor quality of many structured credits was a major point of stress during the GFC. The current agency mortgage-backed security (MBS) market is quite deep in terms of buyers, even if banks need to liquidate their holdings. Commercial mortgage-backed securities (CMBS) will see more stress as smaller banks provide most of these loans, but underwriting standards are higher than even pre-GFC levels.
Opportunities in corporate credit should focus on “premiumization.” Businesses are segmenting their target markets to manage inflation and supply chain challenges by focusing on premium products which are typically higher-margin. This has helped businesses manage the lack of capacity in areas such as leisure and travel. Another area for this premiumization of products is in automobiles, where semiconductor constraints limiting chip availability create the need for higher car prices.
Real estate opportunities focused on sectors with tailwinds post-COVID. Only about 50% of the US workforce is fully back to the office at pre-COVID-19 levels. In this environment, residential housing has two purposes: housing/shelter and an office function, increasing real estate demand. There is still a shortage of housing in the US. Inflation makes it difficult to address the under-building because prices of both materials and labor have risen. There is hope that the continued strong demand will improve new homebuilding activity. In commercial real estate, the industrial and multi-family sectors are strong, while office space is struggling. The lack of use of office space impacts tax revenues, most obviously property tax, but also neighborhood sales tax revenues and income tax revenue.
Higher inflation adds tax revenue in municipalities. Primary tax revenue for municipalities comes from income, sales, and property taxes. The inflationary environment is creating more revenue than anticipated due to wage inflation and increased in the cost of goods and is therefore strengthening the credit quality of many municipalities.
While it is clear that a great deal of uncertainty remains in the global financial markets, the volatility is creating opportunities across a variety of areas within fixed income.
WHAT ARE THE RISKS?
All investments involve risks, including the possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested.
Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in lower-rated bonds include higher risk of default and loss of principal. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. In general, an investor is paid a higher yield to assume a greater degree of credit risk. The risks associated with higher-yielding, lower-rated debt securities include higher risk of default and loss of principal. Because municipal bonds are sensitive to interest rate movements, a municipal bond portfolio’s yield and value will fluctuate with market conditions.
The price and yield of a mortgage-backed security will be affected by interest rate movements and mortgage prepayments. During periods of declining interest rates, principal prepayments tend to increase as borrowers refinance their mortgages at lower rates; therefore MBS investors may be forced to reinvest returned principal at lower interest rates, reducing income. An MBS may be affected by borrowers that fail to make interest payments and repay principal when due. Changes in the financial strength of an MBS or in an MBS’s credit rating may affect its value.
Real estate securities involve special risks, such as declines in the value of real estate and increased susceptibility to adverse economic or regulatory developments affecting the sector.
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1. Source: Nick Timiraos, “Fed Raises Rates but Nods to Greater Uncertainty after Banking Stress,” The Wall Street Journal, March 22, 2023.