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With elevated volatility in fixed income markets and the Fed's rate cutting cycle now underway, we sat down with Brian Shaw, CFA and Justin Bourgette, CFA from the portfolio management team of the Eaton Vance Strategic Income Fund to get their thoughts on the macro environment and to learn where they're currently finding attractive investment opportunities today.
Part 2: Thoughts on Sector Allocation & Duration Positioning
Fixed income markets have performed quite well recently, with the Bloomberg U.S. Aggregate Bond Index up nearly 6% in the last three months and several other sectors faring even better. What are some areas of opportunity you're seeing for the remainder of 2024 and into 2025?
As noted in Part 1 of this blog series, given our view that economic growth will continue to slow, we'd caution investors to be sure they earn appropriate compensation for any risks taken. Having a flexible, global multi-sector approach with a broad opportunity set allows us to identify the best relative value opportunities. And if we aren't being adequately paid to take risk in a specific sector, we won't.
For instance, we can compare investment grade (IG) corporates to agency mortgage-backed securities (MBS). Extremely strong IG corporate demand in recent quarters has tightened spreads to well-inside their long-term median, whereas Fed quantitative tightening and last year's regional banking crisis caused MBS spreads to trade much wider than longer-term averages. In fact, investors can pick up nearly 50 basis points (bps) of spread by moving out of A-rated corporates and into AAA-rated, government-backed agency MBS.1 This proposition of going up in quality and up in yield is very attractive today.
Agency MBS offer advantages on spreads and credit quality
Source: Bloomberg. As of 9/20/24. The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results.
Sticking in the housing market, we believe that non-agency MBS, particularly the bonds originating a few years back, represent an attractive area to take credit risk. The underlying borrowers have built up substantial equity in their homes after the run up in home prices over the last few years. In many cases, these borrowers would need to see a near 40% decline in home prices to lose that equity.2 This, in our view, represents a compelling risk/reward opportunity, especially when considering the attractive yields offered by many of these securities.
What are your thoughts on corporate credit given what appear to be somewhat expensive valuations?
Broadly speaking, valuations across most segments of corporate credit are rich on a historic basis and spreads remain tighter than what we believe to be fair value, so we have maintained an underweight position relative to our past allocations. As noted above, IG corporate spreads trade at very tight levels today, despite the quality of the IG corporate market falling over time, with an increasing proportion of the Bloomberg US Corporate Index now comprised of BBB-rated bonds.
On the high yield end of the spectrum, we feel that spread levels on the ICE BofA US High Yield Index may be understating just how rich the market is, as the wide tails of distressed securities' valuations push headline spreads wider. For example, non-distressed high yield trades at an average spread of roughly 250bps over Treasuries, compared to 315bps for the index.
Distressed high yield spreads mask expensive market
Source: Bloomberg. As of 9/20/24. The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results.
Bank loans have been a bright spot in the credit markets performance-wise in recent years, and their coupons have floated to quite attractive levels following the Fed hiking cycle. Despite high current income, we feel the sector offers limited convexity, as nearly 40% of bank loans trade above-par.3 In addition, technical headwinds could emerge, as coupons fall in line with Fed rate cuts. With that said, there are pockets of the credit markets in which we believe active managers can add value, and one such sector is the collateralized loan obligation (CLO) market. BBB-rated CLOs, for example, offer wider spreads and less credit risk than high yield corporates today.
Beyond the U.S. fixed income markets, are there any specific places abroad that look particularly attractive today?
Emerging markets (EM) debt, which is a sector that's often underrepresented in many investors' fixed income portfolios, is an area where we continue to find compelling opportunities. Generally speaking, policymaking has substantially improved in most EM countries over the past decade, and monetary policy improvements have specifically stood out. Many EM central banks were well-ahead of their developed markets counterparts in recognizing the inflation threat coming out of the pandemic, and most hiked policy rates much sooner than the U.S. Federal Reserve, for example. Those countries are now reaping the benefits of that decision, and their bond markets are benefiting as rates have been cut rather swiftly.
In addition, the U.S. dollar appears quite overvalued relative to history, with the real effective exchange rate at a near 30-year high. The combination of the country's massive current account and fiscal deficits, as well as the potential for Fed rate cuts on the horizon, could result in dollar weakness ahead, and that has historically boded well for emerging markets assets.
Record US dollar strength could see reversal
Source: Bloomberg. As of 8/31/24. The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results.
Not only do we believe in the diversification and yield benefits offered by emerging markets debt, but the sector is also far less efficient than developed markets, which can lead to ample opportunities to generate alpha for skilled, active bond managers.
With the big rally in interest rates since late-April, how would you characterize your duration positioning today?
Investors' perspectives on the benefits of adding duration to a portfolio should be evolving as inflation has come down. Back in 2022 and 2023, when inflation was running near multi-decade highs and interest rates were rising, the correlation between stocks and bonds spiked above +0.6 after spending nearly all of the last two decades in negative territory.
Inflation fall signals bonds' potential hedging benefits
Source: Bloomberg. As of 7/31/24. The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results.
Changes in inflation have historically led stock/bond correlations by roughly 18 months, and in a world of moderating inflation, as we are beginning to see now, bonds may once again serve as a useful hedge to risk assets in investor portfolios, dramatically increasing their value proposition.
In addition to the potential diversification benefits of adding duration to fixed income portfolios,4 we also think it is prudent to gradually extend out the yield curve and risk spectrum in order to preserve today's attractive yields. For many investors, especially those who have been rolling T-Bills or sitting in money market funds, reinvestment risk will be a real concern, as they may see their 5% yielding portfolio today drop into the mid-3% range by mid-2025, if market projections eventually play out.
In our view, there are a variety of fixed income sectors (several noted above) that offer both the ability to preserve today's high yields and the potential for capital appreciation if rates trend lower from here, and we believe that now, more than ever, a flexible, globally-diverse approach can capitalize on such opportunities and generate attractive risk-adjusted returns.
Learn more about the Eaton Vance Strategic Income Fund, including how to access the fund prospectus here.
1 Agency MBS are issued and backed by government entities created by the U.S. Congress, namely the Federal Home Loan Mortgage Corporation (commonly known as Freddie Mac), the Federal National Mortgage Association (Fannie Mae) and the Government National Mortgage Association (Ginnie Mae). The entities guarantee the timely payment of principal and interest on underlying mortgages within the agency MBS.
2 Bloomberg. As of 8/31/2024.
3 Bloomberg. As of 8/31/2024.
4 Diversification does not eliminate the risk of loss.
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