Fixed Income Asset Allocation Insights: Risk Reduction Is Coming, but Not Yet

Risk Management

Performance was mixed across fixed income asset classes in August as Treasury rates traded higher. Investors continue to contend with moderating growth expectations from the rise in Covid-19 infections due to the Delta variant, along with ongoing inflation concerns in the US. In addition, investors reacted to prospects of Fed tapering in the first quarter of 2022 (or even sooner) and increasing geopolitical concerns. Nevertheless, the fixed income market remains skewed toward risk-taking, and investors continue to buy on weakness as they remain comfortable with current central bank support and positive on the longer-term growth outlook.

 

Against this backdrop, our fixed income allocations remain unchanged, and we continue to be constructive on risk assets, buying on weakness. We believe the next move likely will be to reduce risk exposure in the portfolio due to tight valuations and the Fed getting closer to tapering and scaling back its current accommodative measures. In our view, we are not yet at that stage.

US Macro View

Markus Schomer, CFA, Chief Economist

 

Shifting to equal-probability bull and base case scenarios
We reduced our US macro bull case this month and increased the central case. We maintain our equal-probability bull and base case scenarios, each now at 45%, but are signaling that the balance is shifting back toward the latter. We still expect growth and inflation to return in the central case in mid-2022. Near-term indicators such as consumer confidence and purchasing managers’ indices (PMIs) show a loss of recovery momentum. Inflation pressures appear to be peaking, which should take pressure off the Fed. We still await details of another fiscal spending program, which should reduce the risk of a fiscal cliff next year. We also await more details on the Fed’s taper talk.

 

Market movers
Confidence recession. One of the two major consumer confidence indices crashed in August, suggesting something is seriously troubling Americans. Is it the Delta variant, inflation, Afghanistan? Could it be a data error? Without a fundamental driver, sentiment declines aren’t lasting enough to affect the underlying growth trend.


Delta.  In New York, Covid cases still remain well below the January peak. With vaccination rates approaching 60% statewide and probably higher in New York City, the risk of hospitalization remains low. That cannot be said for states like Texas, Georgia, or Alabama, where concerns about Delta may be much higher.


Taper corner.  Taper talk is cheap; acting on it will be much more difficult. The lack of direction from Powell on this issue opened the door for committee members to lean far out the window and fan the flames of second-half tapering. Now the global growth outlook is questioned, Delta is thriving, and we are approaching another debt-ceiling moment. Is that the time to scale down support from monetary policy? We don’t think so.

Target Portfolio Allocations (as of 25 August 2021)

For illustrative purposes only. We are not soliciting or recommending any action based on this material. There can be no assurance that the above allocations will be in any account at the time this information is presented. This material must be read in conjunction with the Disclosure Statement.

Leveraged Finance

John Yovanovic, CFA, Head of High Yield Portfolio Management 

 

Fundamentals
We remain positive after strong second-quarter earnings. Most companies beat EBITDA expectations, says JPMorgan, and have provided positive forward guidance; only 10% of issuers missed on earnings (as of 13 August). Specific industries note labor and input cost pressures, while others are still disentangling supply chains disrupted by Covid. Commodity prices remain mixed but are at healthy levels for producers.

 

Valuations
Treasury and equity volatility leaves spreads range-bound, although Bloomberg US Corporate High Yield spreads have widened 20 basis points (bps) since mid-July to 310 bps (as of 18 August). This area provides some cushion for higher US Treasury yields and is near our 270-300 option-adjusted spread target. BB credit continues to be favored, though returns among rating tiers are closer than in July. Credit dispersion among issuers remains small relative to history, and valuations remain near all-time tights.

 

Technicals
A busy month, with $34 billion priced as of 13 August (JP Morgan Securities) and a continuing mix of first-time issuers and refinancings. Year-to-date (YTD), new issuance of $380 billion is in line with a normal year; 2020 saw a record $441 billion. Rolling four-week flows are zero. The steady new-issue calendar, lighter trading, and market volatility have led to neutral technical conditions despite sharp downside moves in specific issues.

Leveraged Finance Allocation Decision

 

We maintain our allocation of 40%. Amid fair valuations and improving fundamentals, our portfolio risk has remained at 1.0 over the past few quarters. Fund flows have shifted from negative to neutral, but heavy supply creates neutral technicals at best. The improved backdrop justifies spread levels and the implied default rate but doesn’t leave much room for total return away from coupons. Based on current valuations, we are neutral on loans versus bonds; collateralized loan obligations (CLOs) remain attractive.

Investment Grade Credit

US Dollar Investment Grade Credit

 

Dana Burns, Portfolio Manager, US Dollar Investment Grade Fixed Income

Fundamentals
As the economy gets back on track, fundamentals have improved, but shareholder-friendly activity and mergers and acquisitions (M&A) are likely to increase.

 

Valuations
Credit spreads continue to tighten and overall are now trading through long-term averages. Nevertheless, we continue to see attractive opportunities in select credits.

 

Technicals
The technical backdrop for credit is positive due to strong foreign and domestic demand and low broker-dealer inventories. After a busy August, supply may slow as we head into fall.

 

 

Non-US-Dollar Investment Grade Credit

 

Roberto Coronado, Portfolio Manager, Non-US-Dollar Investment Grade Credit

Fundamentals
Neutral. Companies are reporting better numbers as economies start to reopen and leverage has remained under control. As a result, balance sheets in European investment-grade names are in fairly good shape. So far, M&A activity in Europe has remained modest, but the recent rise in transactions bears watching.

 

Valuations
Neutral. Credit spreads are close to fair value at the index level, so we don’t expect a large move tighter; similarly, we don’t see a reason for spreads to widen. We view sector and security selection as the way to outperform.

 

Technicals
Positive. The technical picture has remained positive thanks to continuous buying from the European Central Bank through its support programs, lower-than-expected supply, and strong inflows into the asset class during July.

Investment Grade Credit Allocation Decision

 

We maintain our allocation of 15%. Fundamentals continue to improve and demand has remained strong, particularly from foreign buyers. However, downside growth revisions for the year’s second half, driven primarily by a rise in Covid cases tied to the Delta variant, are concerning. We remain selective in this environment and will add exposure to growth-sensitive names on any near-term weakness.

Emerging Markets

Sovereigns

 

Anders Faergemann, Portfolio Manager, Emerging Markets Fixed Income

Fundamentals
China’s regulatory crackdown highlights a desire by authorities to target a higher degree of social equality and common prosperity, yet we do not expect the measures to derail medium-term growth. While some slippage may occur in the third quarter, partly due to China’s zero-tolerance stance on Covid outbreaks, we expect China’s growth to stabilize around 5.5% next year, following average annual growth of 8.1% this year.

 

Valuations
Sovereign spreads continue to trade in a narrow range, despite being unable to keep pace with US Treasuries in June. Sovereign investment grade (IG) spreads, at +154 bps over the EMBI Global Diversified Index (trading at +355 bps overall), are close to our estimated fundamental fair value, while sovereign high yield (HY) spreads, at +588 bps, still have scope to tighten in tandem with improving fundamentals (JP Morgan and Bloomberg as of 23 August).

 

Technicals
Emerging market (EM) governments took advantage of lower US Treasury yields, causing higher-than-expected issuance in June and July. August is a light cash flow month, which will be outweighed by extra special drawing rights (SDR) disbursements in the third quarter.

 

Corporates

 

Steven Cook, Co-Head of Emerging Markets Fixed Income

Fundamentals
Our positive scores continue as second-quarter results align with our expectations of deleveraging. Within our coverage, companies reporting in Latin America, Central and Eastern Europe, the Middle East, and Africa retain overwhelmingly positive credit trajectories — 36% positive versus 3% negative — over the next six months (PineBridge Investments calculations as of 18 August). Asian results will be key to challenging/ reaffirming our fundamental outlook, which currently is at odds with market sentiment.

 

Valuations
CEMBI Broad Diversified spreads are virtually flat on the month at 260 bps despite some large intra-month moves. The most significant was in China HY, which widened more than 300 bps at the end of July but retraced nearly half by mid-August (JP Morgan as of 17 August). Overall, however, HY spreads were flat in August, so our scores remain unchanged. We remain bullish long-term given the spread pickup on offer versus other asset classes.

 

Technicals
August issuance fell significantly, with $9 billion of supply and $19 billion in scheduled inflows, not including calls/tenders. We expect supply to pick up in September, particularly if sentiment in Asia improves. Overall year-to-date issuance of $372 billion is up 16% year-over-year, but net issuance of $83 billion is 86% of what’s expected full-year, so we anticipate decent digestion. (Data from JP Morgan as of 16 August.)

Emerging Markets Allocation Decision

 

We maintain our allocation of 25%. Market concerns over Fed tapering, China’s regulatory reset, and a rise in the Delta variant have dampened the near-term constructive outlook for EM, yet underlying growth and the recently announced SDR disbursements provide sufficient support for the second half. Overall, continued improving fundamentals and a strong technical picture provide reassurance.

Securitized Products

Andrew Budres, Portfolio Manager, Securitized Products

 

Fundamentals
Mortgage rates are off their record lows, but still low on an absolute basis, and mortgage originators are still able to find customers easily. Fundamentals remain challenging.

 

Valuations
Spreads have widened out about two-thirds of the way to where they would be if the Fed were already slowing down its purchases.

 

Technicals
Supply of mortgage-backed securities (MBS) in the first half came at a torrid pace. It should moderate in the second half, but clearly more MBS will be originated in 2021 than the Fed will be buying.

Securitized Products Allocation Decision

 

We maintain our allocation of 20%. Much of the widening pain of the anticipated Fed taper is already taking place and being priced into MBS spreads. Given the current environment, we are maintaining our neutral stance, but would lean more constructive if there is another move wider.

Non-US-Dollar Currency

Dmitri Savin, Portfolio Manager, Portfolio and Risk Strategist, Emerging Markets Fixed Income

 

Fundamentals
While the US dollar should remain well supported by robust fundamentals, triggers for further strength are less evident. Powell has stressed that the Fed will use current data, rather than economic projections, to evaluate the progress of the US economy toward normalization, hinting very strongly that the Fed’s “maximum employment” target rather than the price-level target will be the dominant factor behind any move to tighten monetary policy.

 

Valuations
We believe the US dollar can gain more against the euro and the Japanese yen once real yields start to rise and break-evens tighten. But that may be a 2022 phenomenon. For now, we are happy to stick with our year-end forecast of 1.1750 within a 1.1500-1.2000 range. We maintain the same range for the next 12 months within an underlying strong US dollar bias.

 

Technicals
According to JPMorgan and International Monetary Market data through 10 August, the most significant change in foreign exchange (FX) positioning since early July has been the elimination of remaining US dollar net shorts. This has partially reflected significant positioning deterioration in the Canadian dollar, the Australian dollar, and the euro.

Non-US-Dollar Currency Allocation Decision

 

We maintain our 0% non-dollar allocation. With the US dollar having already hit our year-end target, we are inclined to hit “pause” and await news on the next economic mini-cycle. Concerns over China’s regulatory crackdown, the aggressive Delta variant, and increased volatility in commodity prices warrant some consideration of the next move in currency markets.

Our Central and Recession Scenario Probabilities Slightly Increased While Our High Growth Scenario Probability Decreased

 

Fixed Income Scenario Probabilities – Next 12 Months (as of 25 August 2021)

Source: PineBridge Investments. For illustrative purposes only. Any opinions, projections, forecasts and forward-looking statements are based on certain assumptions (which may differ materially from actual events and conditions) and are valid only as of the date presented and are subject to change.

About This Report

 

Fixed Income Asset Allocation Insights is a monthly publication that brings together the cross-sector fixed income views of PineBridge Investments. Our global team of investment professionals convenes in a live forum to evaluate, debate, and establish top-down guidance for the fixed income universe. Using our independent analysis and research, organized by our fundamentals, valuations, and technicals framework, we take the pulse of each segment of the global fixed income market.

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