Capital Ideas^TM

Our latest Ahead of the Curve paper examines opportunities for fixed income investors in what is likely to remain a positive environment for the asset class.

The underlying structural and cyclical resilience of the US has enabled it to avoid recession so far; unusually, economic data now points toward the economy returning to mid-cycle. Combined with a slower decline in inflation, this suggests the Federal Reserve (Fed) will continue to cut interest rates but not as fast or as much as the market initially anticipated.

Meanwhile, this relatively benign backdrop should be positive for risk assets in general; in other words, an environment where yields and spreads could remain range bound and rates relatively volatile. This would mean carry (income) rather than duration is likely to be the dominant component of fixed income results.

Our bias is currently towards higher-quality investment grade credit as we believe this area offers better relative value with spreads having tightened. The spread between A and BBB bonds, shown in the chart, is very tight on a historical basis, which means investors are receiving poor compensation for the additional credit risk taken when moving down in quality.  An example of one of the higher-quality areas where we are finding opportunities is pharmaceuticals. Bonds within this traditionally defensive sector are currently available without sacrificing as much spread versus the broader market as has historically been the case.

Relative value considerations also suggest a bias toward investment grade over high yield with spreads between the two close to the lowest levels for 20 years. That said, we believe the attractive level of yield offered, improved credit quality of the index and relatively short duration of US high yield provides a good source of diversified carry for mixed asset portfolios. Examples of opportunities our research has identified include names within the pharmaceutical and independent energy sectors.

Overall, fundamentals across corporate and emerging markets remain constructive, with the outlook supported by the recent shift in Fed policy. Valuations are tight relative to history, but given the positive outlook for economic growth, the carry component remains compelling with select opportunities in investment grade, high yield and emerging markets.