Fixed Income Perspectives: Rates Reach Cruising Altitude, but How Long Is the Flight?

The recent rise in rates, while dramatic, represents a return of the U.S. 10-year real yield to its long-term average. Despite volatility in rates, the Fed will likely be hesitant to cut rates until there’s a significant dip in employment. Investors will need to get used to this “higher for longer” environment, which is creating new winners and losers across the economy and fixed income markets.

Borrowers were the winners in the abnormally low-rate environment that prevailed over the past decade and a half. In this higher-rate environment, savers are finally being rewarded. More established consumers who have owned their homes for a while (and have savings) should benefit from higher rates on their savings accounts, while enjoying insulation from any impact on their mortgages from higher rates. While consumer leverage has risen, it remains below pre-Covid levels. However, delinquency rates on unsecured consumer loans have noticeably risen among lower-FICO borrowers. In fixed income markets, asset-backed securities (ABS) remain a compelling way to gain exposure to the stronger areas of the U.S. consumer market.

While new homeowners/mortgage holders with limited savings are relatively disadvantaged, more than 90% of homeowners have a mortgage rate under 5%, while the current national average for a 30-year mortgage rate is 7%.¹ The struggle across mortgage performance reflects higher rates and higher rate volatility, not credit concerns for underlying borrowers. At current mortgage rate levels, the threat of rate-driven refinancing is virtually nonexistent. This environment is creating opportunities in the mortgage-backed securities market.

We think the discussion on rate increases has run its course and investors should focus on how long the Fed might maintain official rates—cuts will only materialize when labor conditions deteriorate or if something “breaks.” Against this backdrop, higher-quality bonds across fixed income markets offer attractive real yields and should resume their role as a portfolio anchor if fears about a recession grow.

Investment grade corporates

• Investment grade (IG) spreads widened 3 basis points to +121 in September.
• Flows turned negative with the move in rates, and IG credit weakened late in the month due to the broader sell off in risk assets.
• Bank earnings are expected to be solid again, supported by abating concerns around deposit outflows at regional banks. However, the recent move higher in rates has increased focus on banks’ “held to maturity” portfolios.
• We are reducing risk into year-end and waiting for a more attractive entry point amid higher macro volatility.

High yield corporates

• High yield spreads continued to climb in September, and the expectation for weak global growth, higher interest rates, and potential margin compression suggest that spread widening could continue into the near future.
• However, higher all-in yields and a lack of new issuance may keep prices afloat in current market conditions.
• The portfolio is overweight builders/building products, health care/pharma and energy (E&P). The portfolio is underweight technology, utilities and financials.

Senior loans

• Despite the volatility in broader financial markets, senior loans advanced in September. Investors’ appetite for risk continued to benefit CCCs during the month, with the rating cohort outperforming both BBs and Bs.
• At the issuer level, we continue to focus on the potential for weakening EBITDA growth and lower fixed charge coverage ratios.
• We continue to avoid consumer-reliant issuers with weaker credit profiles, particularly companies with discretionary offerings and exposure to a low- to mid-tier consumer, which should face the most downward earnings pressure in the near term. 

Agency MBS 

• Net issuance in 2023 has been revised down to ~$500 billion. The initial ~$300 billion of organic net supply projections has been reduced due to slower home activity and refinancings. Against this backdrop, FDIC liquidations have added much-needed liquidity and supply to the market.
• The performance of agency MBS will be closely correlated with broader volatility and rate directionality in the near term, likely to outperform during rallies and lag during selloffs.
• Longer term, the attractive spreads and carry for mortgages should bolster the agency MBS market. Once rates stabilize, home buyers will emerge, supply will remain low, and the FDIC sales will have ceased.

Securitized credit

• CLOs: While the income-producing attribute of CLOs remains attractive as the Fed continues its hiking regime, the aging of the economic cycle introduces credit risk. This weakens the medium-term outlook for CLOs, given the more leveraged nature of their underlying collateral. 
• CMBS: While the regional banking crisis has stabilized, fallout in commercial real estate continues to be a major source of concern. Against a backdrop of restrictive financial conditions, tighter lending standards should cause defaults to decrease.
• ABS: We continue to overweight ABS, which provides access to a diverse mix of sub sectors, offers access to the U.S. consumer, and has robust structures with relatively short spread durations.
• Non-agency RMBS: Mortgage credit has remained stable throughout this housing cycle, supported by strong underwriting, a favorable regulatory regime, homeowners’ access to historically high home equity, and a resilient labor market.

Emerging market debt 

• While China’s policy response appears to have stabilized economic activity, growth in the region is likely to slow, as housing trends and private sector confidence remain negative.
• Inflation continues to moderate across most emerging market (EM) countries, although higher commodity prices are a risk.
• Overall, EM corporate fundamentals remain resilient, and corporate financial policy remains prudent