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Multi-sector income: Investing for income as rates rise
Damien McCann
Kirstie Spence
Xavier Goss
May 4, 2022
Markets are on edge over soaring consumer prices, the war in Ukraine and recession fears in the U.S., Europe and China.
The Bloomberg U.S. Aggregate Bond Index, a broad representation of the U.S. bond market, declined 5.9% in U.S. dollars in the first quarter, the worst quarterly loss since 1980. In April, it was down another 3.8%. With bond returns battered, investors may be wondering if there are any bargains in fixed income markets. Given the low prices, is now a good time to buy?
The risks are real. The U.S. Federal Reserve’s efforts to contain inflation are likely to pressure growth and employment in the near term as its outlook remains hawkish.
Rate hike expectations have jumped
Sources: Bloomberg, Federal Open Market Committee. Projections assume rate at year-end.
And as Europe seeks to wean itself from Russian oil and gas, energy prices — up 38% year-to-date — may remain elevated.
Against this challenging backdrop, three of our fixed income portfolio managers with Capitals Express Investments Multi-Sector Income FundTM (Canada) offer their views about what’s ahead for some of the riskier bond market sectors. (Multi-Sector Income is available to investors as of June 30, 2022.)
Companies are benefiting from consumer demand, but expect a more volatile environment for credit
Damien McCann, fixed income portfolio manager
The Fed seems intent on trying to slow economic activity. Rate hikes tend to impact economic activity with a lag of at least two quarters. Right now, corporate fundamentals are fairly strong, and companies are benefiting from a consumer that is able to withstand price increases. I am seeing early indications that lower income consumers are spending less, but overall, there is no significant pullback.
Inflation is a major concern, and Russia’s invasion of Ukraine has only added fuel to the fire. The economic toll of the invasion has far-reaching effects that are not yet fully visible. Obviously there has been an impact on the energy and grain sectors, but it has also spilled into certain parts of auto manufacturing and industrial gasses the semiconductor industry relies on.
Food and autos are more exposed to higher input costs and shortages compared to telecom and cable, or health care companies.
Spreads have widened over the past year, and it is a more volatile environment for credit. The issuance of high-yield bonds has dropped dramatically as companies wait for things to settle down.
As an active manager, I have the flexibility to react to these ongoing shifts.
The returns across investment grade, high yield, emerging markets and securitized debt are not the same over time. Being flexible and adjusting your portfolio can help buffer some of the current headwinds. There have been more opportunities in investment-grade bonds over the past few months, but I still think high-yield bonds offer better value.
Within investment-grade corporates, certain California-based utilities seem attractive. In high yield, energy companies have some upside. In my view, oil prices will stay fairly high as supply is likely to remain tight. Beyond Russia, U.S. energy companies have a labour shortage problem which will limit increases in drilling activity. People in West Texas can work remotely and earn the same wage as if they were working on an oil rig.
Among high-yield credits, I also see value in insurance brokerage and financial advisory issuers. These are resilient business models that can withstand high leverage.
Valuations and fundamentals suggest cautious optimism for emerging markets
Kirstie Spence, fixed income portfolio manager
What’s happening in Ukraine is heartbreaking. I’ve dealt with many crises in my 25-plus years of investing in emerging markets, and this one is uncharted territory on so many levels.
I think it’s prudent to stay cautious given the heightened volatility from war, inflation and the slowdown in China. However, there are idiosyncratic opportunities in emerging markets debt that an active manager can pursue.
Bonds across many emerging markets have traded lower, but some of that trading has been related to risks tied to inflation and what central banks are doing. The asset class has matured significantly over the past decade. I think valuations generally reflect some downside risks.
Overall, fundamentals are fairly decent. Several emerging markets banks have raised rates dramatically to combat inflation. And in some markets like Brazil, investors are being fairly compensated for elevated inflation. I also think certain currencies may even be cheap by historical standards.
There are bright spots. Commodity exporters such as certain Latin American-based countries have traded higher, as surging prices could help them withstand a slowdown in global growth.
Proactive rate hikes could provide attractive entry points for some emerging markets
Source: Bloomberg. Data shown as of 4/30/2022.
Securitized assets may be more resilient compared to other bond sectors as inflation and rates rise
Xavier Goss, fixed income portfolio manager
Securitized assets cover a wide gamut of sectors such as U.S. residential mortgages, auto loans, commercial real estate and student loans. Broadly speaking, asset-backed securities and commercial mortgaged-back securities have some upside even with higher inflation. Select areas appear attractive compared to corporate credit, particularly at current spread levels.
I remain a bit cautious as tighter monetary policy will slow growth and loan demand. That will flow through and impact consumer spending. I expect an uptick in delinquencies and defaults as eviction moratoriums and other pandemic-era programs roll off. While the increase could be higher than pre-pandemic levels, it shouldn’t be exceptionally so because consumers are in a better financial position today as compared to past financial crises.
Consumers in the U.S. may be better prepared to weather an economic slowdown
Sources: Capitals Express Investments, Federal Reserve Bank of St. Louis, National Bureau of Economic Analysis, Refinitiv Datastream. Personal savings figures are seasonally adjusted and released quarterly. All prices shown in USD.
I have been spending more time meeting with loan originators to better understand their specific underwriting standards. As financial conditions tighten, there may be a bifurcation in deal performance as weaker originators loosen their underwriting standards to maintain current loan volume.
In the current environment, I foresee more bespoke and privately negotiated transactions across the securitized space, particularly as security selection becomes a more prominent driver of returns. This is especially relevant in the consumer asset-backed securities market where there are more niche issuers.
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Lower rated bonds are subject to greater fluctuations in value and risk of loss of income and principal than higher rated bonds.
The use of derivatives involves a variety of risks, which may be different from, or greater than, the risks associated with investing in traditional securities, such as stocks and bonds.
Bloomberg U.S. Aggregate Bond Index represents the U.S. investment-grade fixed-rate bond market. The index is unmanaged and, therefore, has no expenses. Investors cannot invest directly in an index.
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