Risks to be conscious of
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Fixed income fund managers and asset allocators have plenty to think about. That much was evident at PGIM Investments’ roundtable held to discuss fixed income investment opportunities amid economic uncertainty. How quickly will economies rebound from the Covid-19 pandemic? How sticky will inflation prove to be? And when can we expect tapering and the first interest-rate hike? All of that was up for debate. The longer-term outlook for the economy may be anything but certain, with many risks to put in the ‘book of worry’. However, the mood around the virtual table was one of cautious optimism. The sharp selloff in financial markets last March led PGIM Fixed Income managing director Greg Peters to coin the term ‘the golden age of credit’. While valuations have since rebounded strongly, panelists detailed myriad relative value opportunities they are finding in fixed income markets. The ability to favor loans over bonds or developed over emerging markets, for example, underlines the alpha-adding potential of active managers who have the run of the market and can be nimble in their asset allocations. And with many investors losing money in real terms by holding cash instead of investing in bonds, where attractive yields are available, there is value to be had in talking to clients about their fixed income allocations.
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This material is being provided for informational or educational purposes only and does not take into account the investment objectives or financial situation of any client or prospective clients. The information is not intended as investment advice and is not a recommendation. Clients seeking information regarding their particular investment needs should contact their financial professional. Investing involves risk, including possible loss of principal. Some investments have more risk than others. Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise. Past performance does not guarantee future results. PGIM Fixed Income is a unit of PGIM, Inc. (PGIM), a registered investment advisor. PIMS and PGIM are Prudential Financial companies. © 2021 Prudential Financial, Inc. and its related entities. PGIM and the PGIM logo are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide. 1052799-00001-00
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Silver lining
Panelists may have gathered around the virtual roundtable to discuss PGIM Fixed Income’s report, ‘Fixed Income Investment Opportunities Amid Economic Uncertainty’, but one thing was unanimous: the US economy is on a tear. Lawrence Gillum, fixed income strategist at LPL Financial, highlighted the broker’s mid-year outlook, fresh off the press and entitled ‘Picking Up Speed’, in which it increased its GDP forecast for 2021 from 4% at the start of the year to 6.5% as the resilience and speed of the recovery far surpasses its expectations. ‘Both times we thought we were being overly optimistic, but it’s probably going to turn out that we’re a bit too pessimistic because the economy is continuing to surprise on the upside,’ he said. ‘[The recovery] has been uneven. The labor market hasn’t kept up. We think that will normalize over time. It has been a great economic story for the most part. So, we’re optimistic about the economy and markets for the foreseeable future.’ PGIM Investments had already been at where LPL Financial has arrived. It expects GDP to soar this year before falling closer to trend levels by 2023 – in line with what both the Federal Reserve and International Monetary Fund have indicated. ‘We’re expecting 6.5% roughly for the US and globally [this year], but then next year, it comes off that boil and we’re looking at closer to 4.5% for the US and more like 4% globally,’ said principal Lindsay Rosner. ‘We’ve got the peak of growth happening right now.’ The other big piece of the puzzle is inflation. The economic rebound from the nadir of the Covid-19 pandemic, spurred on by President Biden’s $1.9tn stimulus package and stronger bounce in consumer demand than supply chains can handle, is stoking prices more than policymakers and economists had anticipated. The US rate of inflation has been running at more than 2% since March and in June hit 5.4% – the largest spike since 2008. ‘We’ve certainly had some eye-popping trends in the past couple of months, which will probably continue over the summer and into the fall,’ Rosner said. ‘But just like GDP, inflation is likely to rollover – we’re in the transitory camp.’ She believes we are experiencing – to borrow a term used by Federal Reserve chair Jerome Powell at the Senate Banking Committee on the morning of the roundtable – ‘unique’ inflation. Powell used it in defence of the central bank’s stance to keep providing support to the economy, despite inflation running at uncomfortable levels. A few days later, under questioning from a special House panel, he said a repeat of 1970s-style inflation was ‘very, very unlikely’, primarily because of the Fed’s commitment to price stability. And he continued to attribute most of the recent rise in inflation to areas affected by the pandemic, among them airline tickets, hotel prices and lumber, alongside generally surging consumer demand. ‘It [inflation] is because of the pandemic – the bottlenecks, the breakdowns in supply and now, this surge in demand,’ Rosner said. ‘We think that’s going to roll over.’ Relative performance Such a view contributes to PGIM Investments’ generally optimistic outlook and leads it to being slightly overweight duration. How the recovery is unfolding across different sectors is also shaping outlooks and positioning among panelists. Bank of America Merrill Lynch publishes a monthly report detailing adjustments to its sector views to reflect the ongoing reopening and recovery of economies. Most recently, it upgraded materials to a slight overweight and moved real estate and consumer discretionary to a slight underweight, with healthcare moving to neutral. ‘This is based on relative performance turning lower as some of the momentum that we saw in those sectors declines,’ said Jeff Miller, a director and team lead for fixed income due diligence at Bank of America Merrill Lynch. For UBS, the increasing strength of the consumer will underpin the asset-backed and mortgage-backed securities (MBS) markets. The asset class tends to have higher returns, higher yields and lower interest rate risk than comparably rated corporate bonds. ‘There’s any number of ways that you can play this,’ said Glen McDermott, UBS’ director of investment management research. While some investment managers are bullish on legacy MBS, issued prior to the global financial crisis, especially those higher in the capital structure, others are investing in post-financial crisis securities in the mezzanine part of the capital stack due to better underwriting standards. UBS has been actively analyzing three types of strategies, the first of which is ultra-short multi-sector funds. ‘We’ve found that investors are increasingly looking to move up the curve out of money market funds given the low yields,’ said McDermott. ‘Some managers remain in both high-grade corporates and MBS high in the capital structure and they’ve been performing well in the multi-sector, ultra-short part of the curve.’ Longer-duration multi-sector propositions are also interesting. ‘These strategies are often loosely constrained and investment managers have lessened exposure to investment grade, and to a smaller extent high yield, and reallocated into structured products,’ continued McDermott. Finally, securitized mortgage funds help investors to express views on US homeowner prepayment behaviors, including the probability of default. Talking about tapering The withdrawal of policies that have kept interest rates ultra-low is another key factor for portfolio construction. When can we expect tapering and the first interest-rate hike? The Fed has shortened its timeline on monetary tightening with its so-called dot plot of projections now indicating at least two interest rate hikes in 2023. In surveying the outlook, one area that Bank of America Merrill Lynch is monitoring closely is real estate. ‘Even with the 30-year fixed rate just off historic lows, tight inventory has really underpinned rising home prices,’ said Miller. ‘This has dented affordability and hurt sales activity. We do not think there’s going to be [interest rate] hikes any sooner than early 2023, but we are closely monitoring yields and higher levels of inflation.’ For LPL Financial, the housing market is healthy and not flashing any warning signs, despite house prices increasing at a rapid clip. Its baseline expectation is for the Fed to start talking about tapering at its annual policy symposium in Jackson Hole, Wyoming, which is taking place in-person this year from August 26-28, or in September. ‘We think it’s going to start talking about tapering here shortly, with actual tapering taking place early next year,’ said Gillum. Based upon history, he expects to see an equal prorated reduction of bond purchases from Treasuries and mortgages over the course of 2022, followed by rate hikes at the end of 2022. ‘There’s a ton of liquidity in the marketplace right now and for the Fed to continue to provide this emergency level of accommodation is unnecessary,’ he added. ‘We’d like it to speed up the process more than it’s willing to.’ Rosner at PGIM Fixed Income agrees that the level of ongoing support seems too high and believes that tapering will prove ‘a non-event’. Miller at Bank of America Merrill Lynch sounded a note of caution, however. ‘Investment cash on the sidelines continues to grow and this is one factor of market sentiment that is still a little cautious versus conventional wisdom, which suggests that there could be a little too much enthusiasm for risk assets right now. ‘This could be a factor that could signify rates may remain on the lower end of projections.’
The panel gives its take on what investors can expect next in the unfolding economic recovery
This material is being provided for informational or educational purposes only and does not take into account the investment objectives or financial situation of any client or prospective clients. The information is not intended as investment advice and is not a recommendation. Clients seeking information regarding their particular investment needs should contact their financial professional. Investing involves risk, including possible loss of principal. Some investments have more risk than others. Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise. Past performance does not guarantee future results. PGIM Fixed Income is a unit of PGIM Investments, Inc. (PGIM Investments), a registered investment advisor. PIMS and PGIM Investments are Prudential Financial companies. © 2021 Prudential Financial, Inc. and its related entities. PGIM Investments and the PGIM Investments logo are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide. 1051015-00001-00
‘We’ve got the peak of growth happening right now’
Lindsay Rosner Principal, PGIM FIxed Income
From global investment-grade and high yield to loans and emerging market debt – where are the best opportunities in credit?
At the height of fears over the coronavirus pandemic, and the depths of the market meltdown last March, PGIM Fixed Income managing director Greg Peters and his team hailed a ‘golden age of credit.’ Decimated credit valuations, coupled with the belief that companies will be forced to finally prioritize debtholders, created a highly attractive entry point. ‘A lot has changed since then,’ said Peters, who moderated the roundtable. He pointed to the ‘ferocious’ rebound in bond markets and ‘tremendous’ pickup in mergers, acquisitions and leveraged buyout activity. ‘But it does seem like we’re still very much in this early stage of the credit cycle. Arguably, valuations might be later stage. So, let me pose the question. Is credit still in this golden age? Is credit still an allocation that makes sense?’ Although valuations across the board may not be as compelling as they once were, around the virtual table there was a generally constructive view on credit with panelists seeing greater merit in certain subsectors of credit markets over others. ‘It’s definitely a market where it pays to be selective and which favors those shops that do deep credit analysis and identify idiosyncratic opportunities versus buying the larger market, which you could do last summer when the entire market rallied significantly,’ said Glen McDermott, director of investment management research at UBS. We collate their views below, which serve to underline the importance of a go-anywhere credit strategy that can tap into a broad range of opportunities. Loans versus bonds UBS prefers strategies with exposure to floating rate leveraged loans relative to those investing only in high yield bonds. ‘We really don’t think there’s much there in terms of additional tightening for high grade, whereas in high yield there may be some opportunities lower down the credit curve,’ said McDermott. ‘We analyze both strategies that focus solely on high yield bonds, as well as high income strategies that invest in both bonds and loans. We are more bullish on floating rate leveraged loans versus high yield bonds.’ In terms of implementation, some clients are favoring high income funds that allow managers to find relative value opportunities – loans versus bonds, for example – while other investors are sticking to pure bond or loan strategies. Is a loans versus bonds allocation an interest rate or a credit decision? ‘Maybe it’s a little bit of both,’ said McDermott. ‘When you invest in leveraged loans, the credit quality is going to be lower than in high yield bonds. ‘Differences in credit quality have to be considered, certainly, but given the fact that there has been so much government support and so much terming out of debt, high yield defaults are low – default rates are really banging along the bottom. ‘Even though the average credit quality in the loan market is lower than the high yield bond market, investors are still attracted to the asset class given the floating rate, secured nature of the underlying assets.’ Bank of America Merrill Lynch also prefers an allocation to senior floating rate bank loans than unsecured high yield debt. ‘We allocate to both, but the lower interest rate exposure, minimal energy exposure in bank loans as well as the secured nature of that market are positives,’ said Jeff Miller, a director and fixed-income due diligence team lead. Investment grade versus high yield Even with spreads at near post-pandemic tights, Bank of America Merrill Lynch is positive on investment grade credit. ‘We’re still constructive on credit – it’s our one overweight in fixed income,’ said Miller. ‘Right now, most of the credit managers we talk to are overweight high yield, whereas we believe that credit losses in investment grade are manageable and they’re not a big part of the spread, but the same cannot be said for high yield. ‘High yield at 4% offers meagre compensation for the risk you’re taking. Some of the positives that we see within investment grade credit is the support that it’s received from the Fed and the technical backdrop is very supportive. You have strong demand right now and supply is waning through the balance of 2021. ‘The key risk here is spread volatility in response to movement in Treasury yields. With the 10-year back under 1.3% there’s room for rates to go back up. This may impact investment grade credit more so than high yield due to the lack of a spread cushion that you would have in investment grade relative to high yield.’ Developed versus emerging markets Given its outlook for robust economic growth and inflation proving transitory, PGIM Fixed Income likes high yield the most – and specific names within that part of the market. ‘Back to this understanding that the easier beta compression or spread rally trade is over, it’s finding those pockets of the market that will outperform; trying to use that lens to find the pockets and then building the portfolio from there,’ said principal Lindsay Rosner. She pointed to emerging markets struggling in the first quarter of this year before rebounding in the second – very much led by high yield. ‘There were obviously some losers there, but whatever did survive has rebounded tremendously,’ she said. From a longer-term perspective, however, the risk of Covid-19 and spread of new variants is more greatly affecting emerging markets where vaccine rollout programs are less advanced. ‘We are biased to developed markets right now because of those kinds of things, but there’s a lot of opportunity when you have the right kind of people in the seats to look deeper – not just high level – and can really pick the right kinds of structures and the right kinds of bonds,’ added Rosner. Hard currency versus local currency Emerging market (EM) debt is an area of interest to UBS for several reasons, including the persistently low yield environment. It thinks of the space in term of hard currency debt funds, local currency debt funds, and funds that blend the two. ‘Some of these options are quite appealing if you buy into the emerging markets long-term growth thesis, urbanization trends, emerging markets GDP as a growing portion of global GDP, and you want to tap into these trends in a diversified, fixed income fashion – essentially, a strategic asset allocation to emerging market debt,’ said McDermott. One approach is to build a hard currency strategic allocation to emerging market debt as a cornerstone, with a smaller tactical allocation to local currency bonds. ‘Local currency debt has attractive qualities including ample liquidity but it can be very volatile, so investors will often limit its share of an overall allocation to EM debt,’ continued McDermott. ‘Generally – and we’ll put aside views on the US dollar for the moment – building a strategic asset allocation predominantly in hard currency, both corporates and sovereigns, with some sort of reasonable allocation to local seems to make sense for some investors, depending on an investor’s profile and risk tolerance. ‘It certainly is not for every investor. If appropriate though, the question is implementation. Do you go with a manager that’s a specialist in each of those categories or do you hire a manager who blends both local and hard? ‘That’s investors’ choice and it’s really up to us in our seat to offer the investor a toolbox and they can go in and pick the tools they want to use to articulate their views.’
Greg Peters Managing director, senior portfolio manager, PGIM Fixed Income
‘The belief that companies will be forced to finally prioritize debtholders created a highly attractive entry point’
Gregory Peters, head of multi-sector and strategy at PGIM Fixed Income, is optimistic that the credit market still offers attractive opportunities, but his enthusiasm has faded somewhat. Here he muses about investing in post-Global Financial Crisis (and post-COVID) times, explains why he avoids single-A corporates these days, and offers reassurance for all the inflation pessimists. Q: Last year, you declared that we’ve entered a golden age of credit. Do you still believe that? A: I do. When I came up with that phrase in March 2020, valuations were extreme, and history tells you that buying at those levels has always proven to be a good starting point. The decision to herald a golden age of credit was also based on a ‘back-against-the-wall’ sentiment that was prevalent in the market at that time. Companies’ leverages skyrocketed as their cash flows suffered from lockdowns, but then a rapid fundamental improvement kicked in. Fast forward to today. Valuations have moved higher pretty substantially, and fundamentals are still improving. That makes me think the golden age of credit is likely to be a much more compressed cycle than I initially anticipated. Don’t get me wrong. I still think the cycle holds, even though it’s not going to be the typical multi-year phenomenon it usually is. We’re getting closer to the end. Q: Is the end already in sight? A: I’m not sure what the timeline will look like. What’s interesting here is that valuations have sped ahead of fundamentals. We’re still in this strong, early-to-mid-cycle fundamental repair stage, yet valuations are reflective of a late cycle. Valuations always lead, of course. These days, however, they’re leading in a way we haven’t witnessed previously. Q: What other challenges do you see on the investment side? A: For one, we’re at post-Global Financial Crisis tights. Yes, gross domestic product measures have come roaring back, but we’re still under the trend line. Just take a look at corporate leverage, which, entering this cycle, was the highest we’ve ever seen in a non-recessionary environment. It spiked as cash flows were hit. Leverage is improving now, yet it’s still above where it was going into the COVID crisis. That’s a very interesting backdrop. Secondly, we need to face the fact that trough leverage will be higher than the previous peak. So, you’re not getting to the same deleveraging you’ve seen historically, which makes the market trickier. Lastly, many COVID-affected sectors are still not out of the woods. Cruise ships, for instance, are trading tighter now than they did before the pandemic. Yes, they reliquefied, and they’ve been able to get financing to fight another day, but they’re still not booking. Forecasts suggest that it will take another two years until they reach 80% of their pre-COVID booking status. Q: Where do you see opportunities in the bond market now? A: There are many fewer opportunities today than there were a year ago when credit spreads were extremely wide and yields jumped higher. The challenge we currently face is that valuations largely reflect the strong fundamental tailwind that’s supportive of credit. Q: What does that mean? A: One, we still see value in the high yield bond market, as it should benefit the most from a continued fundamental improvement. For example, we see much more value in high-yield than in investment-grade corporates. Long-end investment-grade corporates especially are an area that looks fully valued to us. Two, we continue to like triple-B corporates relative to single-As. The former are the companies that typically still have their back against the wall and push for fundamental improvement. That’s unlike single-A companies, where the probability of fundamentals moving against us is higher. Just take a look at the uptick in mergers and acquisitions and leveraged buyouts. Q: Do you have plans to go back to single-As any time soon? A: No, I think single-A companies are typically the most exposed among investment-grade bonds. Last year, when everything widened out, we were fine adding single-A exposure as a way of adding spread duration to the portfolio. We felt that these companies, given the uncertainty around the reopening after COVID, would behave quite well. The thing about single-A companies is that they’re really comfortable with moving to a triple-B rating. They often have the bias to add leverage and get downgraded, not upgraded, so you always have to work against that bias. That’s why we think it’s kind of a perverse investment theme. In contrast, triple-B companies have no intention at all to add more leverage and get downgraded to high yield because it’s a very segmented marketplace. Those larger-cap types of triple-B companies really want to hold onto their rating. Q: What’s your stance on structured products? A: Last year, we felt there was more value in corporate credit versus structured products. But given where we are now from a valuation perspective, we continue to see value in the structured product side. That includes higher-quality AAA-rated collateralized loan obligations (CLOs), double-A CLO tranches, commercial mortgage-backed securities, and even portions of asset-backed securities. Q: What impact will inflation concerns have on the credit market? A: Inflation has been a real narrative to say the least. As we came out of the pandemic, the base effects from the reopening—including supply chain issues—hit all at once, which led to an uptick in inflation. Ultimately, though, you’re always fighting disinflation, not inflation. In other words, injecting a little inflation into the system is actually a good thing. I think it’s good for companies and economies. The real question is, how much is too much? Honestly, though, I think we’re a long way from that. We see the current rise in inflation as transitory, with many issues correcting themselves over time. Q: What makes you think that? A: Take the supply chain issues that have created inflationary pressures as an example: lots of them have already started to fade. I also think accompanying labour issues in the US will start to fade away in September when kids are back in school and stimulus cheques run out. And Europe just has to continue to fight against deflation.
DISCLAIMER: This material is being provided for informational or educational purposes only and does not take into account the investment objectives or financial situation of any client or prospective clients. The information is not intended as investment advice and is not a recommendation. Clients seeking information regarding their particular investment needs should contact their financial professional. Investing involves risk, including possible loss of principal. Some investments have more risk than others. Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise. Past performance does not guarantee future results. PGIM Fixed Income is a unit of PGIM, Inc. (PGIM), a registered investment advisor. PIMS and PGIM are Prudential Financial companies. © 2021 Prudential Financial, Inc. and its related entities. PGIM and the PGIM logo are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide. 1050523-00001-00
Greg Peters Head of multi-sector and strategy PGIM Fixed Income
The mood around the table was upbeat, but what risks could derail the positive investment environment?
Roundtable moderator Greg Peters, managing director and senior portfolio manager at PGIM Fixed Income, canvassed opinion around the virtual room on possible risk to put in the ‘book of worry’ – however unlikely – and threw in a couple more himself. 1. Resurgence of Covid The most obvious risk is a resurgence of the Covid-19 virus – the delta variant and any others that emerge. ‘Severe cases [of delta] have been limited, which is encouraging,’ said Lawrence Gillum, fixed income strategist at LPL Financial. ‘Valuations are as tight as we’ve seen in a number of years. Markets are really priced to perfection, so any macro unforeseen event that could make spreads widen out significantly is certainly a risk that we’re thinking about.’ 2. Recession aftershocks This was an unusual recession, so could the aftermath be different, too? ‘This past recession wasn’t a typical recession, where capital (human and otherwise) is cleared out and reallocated to more productive uses – a dynamic process of destruction and rejuvenation,’ said Glen McDermott, director of investment management research at UBS. Rather, unprecedented global governmental fiscal and monetary stimulus has kept companies that would otherwise have gone under – so-called ‘zombie’ companies – afloat. ‘I don’t think there’s any trouble there in the near term, but longer term you have to think to yourself, will all these businesses, including real estate companies, survive once exogenous measures are withdrawn? ‘Once unprecedented amounts of fiscal and monetary stimulus have dissipated, do we have viable businesses across the corporate landscape or will there be trouble in the medium to long term?’ Jeff Miller, director and fixed income due diligence team lead at Bank of America Merrill Lynch, highlighted possible dislocations in commercial real estate markets: ‘With workers returning to offices, we’ll see how the corporate real estate and retail markets react longer term.’ 3. Unemployment For McDermott, the chief risk to strong consumer credit fundamentals is persistently high unemployment. ‘In September, stimulus programs will start to phase out and, in terms of the Cares Act, forbearance programs will be scaled back. That’s a risk – the risk of higher unemployment and reduction of government programs that leads to consumer loan and mortgage defaults that ripple through the economy and then, ultimately, through asset-backed and mortgage-backed securities.’ He rates the probability of this as low, owing to four key factors. Firstly, economic growth is poised to run at 7% for the remainder of this year and 5% in 2022, based on International Monetary Fund estimates.Secondly, unemployment peaked at 14.8% last April and has fallen to 5.5% with expectations for it to decline to around 4% next year. Thirdly, forbearances and delinquencies are correlated and falling in tandem. Delinquencies are running at about 6.3%, still above the long-term average of 5.3% but nevertheless continuing to decline. ‘Interestingly, if you look at 30-day delinquencies, they’re at the lowest level since 1979 and if you look at 60-day delinquencies on mortgages, they’re at the lowest level in 20 years,’ said McDermott. Finally, from a fundamental perspective, mortgage rates are hovering around 3% and refinancing options for homeowners are good. ‘There has been huge growth in the value of properties and corresponding growth in homeowner equity in properties. In addition to that, after the global financial crisis, underwriting standards have been very solid and then finally, the stimulus helped a lot. In fact, by some accounts, only a third of the stimulus was used on spending and the other two-thirds was used on savings and paying down bills.’ Lindsay Rosner, principal at PGIM Fixed Income, raised the question of permanent economic scarring from the virus, notably the millions of unemployed people who may not find their way back into employment. ‘Maybe the entire landscape has changed and they’ll be left behind,’ she said. ‘Going forward, what does the social safety net look like and how do you finance that and what does that mean for our economy long term and the debt burden? That is a real long-term question.’ 4. Policy error For Miller at Bank of America Merrill Lynch, potential policy error is a key risk. Has the Federal Reserve called inflation correctly? Meanwhile, Gillum at LPL Financial is concerned about the monetary mistake that may take place under the new average inflation targeting framework. ‘If the Fed waits too long to hike rates, maybe it has to play catchup and hike rates faster or higher than the market’s expecting, which would likely slow economic growth,’ he said. 5. Risk aversion A risk to outperformance is that spread products stay rangebound for the intermediate term and investors remain heavily invested in this area and in cash and cash alternatives. ‘I think a lot of folks are wrestling with an uncertain market,’ said McDermott at UBS. ‘Staying cautious vis-à-vis duration and maintaining large cash positions may make sense if volatility comes to the fore at some point. If not, you may have extended subpar performance. That’s a risk of nothing happening, essentially.’ Other risks include risk aversion in terms of spreads or yields on new issues. ‘You may recall last year that some of the Treasury auctions were undersubscribed and there could be some potential short-term problems with new issues,’ Miller said. ‘A risk that may affect municipals more than taxable bonds include the infrastructure plan and potential changes to the tax code. In municipals, investors are factoring in pretty steep tax hikes, but if those do not happen, does that impact the price of municipals going forward?’ 6. Oil shock Peters added a potential oil shock to those risks outlined by the panelists. ‘Obviously, it’s tied to inflation – inflation not being transitory would be a market-moving event. It’s not best case, clearly, and so oil embedded in that is something to fret.’ 7. China’s showdown A greater economic slowdown in China than anticipated is another. ‘[China] obviously has a demographic problem that is beginning to bite without a social safety net as well. So, that’s something to put into the book of worry.’ Though some of these risks may not be sufficient to derail the positive backdrop for fixed income and many may not materialize, participants made the case for being active with allocations. ‘Active is likely to outperform passive for the rest of the cycle – the beta trade has largely run its course,’ Gillum said. ‘There are going to be some winners and losers within individual sectors and industries. If you have that active management expertise to differentiate between those winners and losers, that’s going to add value over time.’ McDermott suggested two possible routes: building a portfolio across multiple actively managed single sector funds or hiring a manager that goes across sectors within one fund. ‘High grade, and to a certain extent high yield, has run a lot of its course since last summer and the ability to pivot and look at other sectors like CMBS [commercial mortgage-backed securities], RMBS [residential mortgage-backed securities] and non-traditional ABS [asset-based securities] are ways that a manager of a multi-sector fund or an investor on his or her own can rebalance exposure to markets. ‘That whole rebalancing is important, whether the underlying fund is managed or allocations to static funds change over time.’
Glen McDermott Director of investment management research, UBS Financial Services
‘Do we have viable businesses across the corporate landscape, or will there be trouble in the medium to long term?’
Making the case to clients for allocating to bonds
It’s an important conversation. There’s a slide we like to include in all our market outlooks and presentations, which looks at the household balance sheet and how US households are invested. As of right now, it’s 57% in equities, 26% in cash and 17% in bonds. It really stands out when cash is basically earning you zero. You should, as a minimum, think about moving that cash into something that can earn a decent yield.
Talking about… ALLOCATING ASSETS
Source: Federal Reserve Board/Haver Analytics as of 30 September 2020. Look through approach for mutual funds, retirement funds excluded. Household sector includes non-profits, domestic hedge funds, private equity funds and personal trusts. Cash relates to deposits plus money market mutual funds plus open market paper minus consumer credit minus bank loans and other loans
Talking about… INFLATION
It’s an important conversation to have, especially given the cash that’s sitting on the sidelines. While we do think inflation is transitory, if you’re sitting in cash while we’re having these kinds of inflation moves, it’s not helping you. It’s helping you even less right now.
Source: Bureau of Labor Statistics
Talking about… RISK AND RETURN
If you think about the aging population and where we are from a demographic perspective, we should see more fixed-income allocations across portfolios. You can think about it simply, as you move out of the curve from Treasuries into rates and overlaying on top of that something like high yield or investment grade for that additional spread or even some structured products with credit enhancement.
Financial markets are always anything but certain. As we emerge into a ‘new normal’, the global economic outlook is open to much conjecture. But uncertainty breeds opportunity – especially for those investment managers with well-resourced research teams and the ability to be nimble in their allocations to take advantage of idiosyncratic opportunities, as those dialed into PGIM Investments’ fixed income round table are astutely aware.
Opportunities amid uncertainty
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