Despite rising inflation and continued economic uncertainty, compelling fixed-income investments exist in key assets and sectors.
Jim Caron Chief
Strategist and Portfolio Manager, Global Fixed Income Team, Morgan Stanley Investment Management
Though the new year began with a wide range of economic expectations, the lack of market consensus is creating a robust array of asset selection opportunities for active fixed-income investors.
The key variable for the markets is, of course, inflation. If it proves transitory and eventually recedes enough this year, the U.S. Federal Reserve may merely tap the brakes when it comes to raising interest rates and tapering asset purchases, allowing the economy to run hot and keeping default risks low. But, if inflation persists and becomes a bigger roadblock, the Fed may tighten financial conditions, contracting future growth and increasing default risk. Either case would have a profound impact on asset valuations.
Current market pricing indicates a short, but sharp, tightening cycle from the Fed, and the flattening of the yield curve from the fourth quarter of last year indicates growth will likely moderate in the future. Many indices are already repricing for this outcome, and in the search for returns above benchmarks, we see the most compelling fixed-income investments in four key areas: Investment-grade corporate bonds, high-yield bonds, securitized credit and emerging-market debt.
Select Investment-Grade Corporate Bonds
Among corporate bonds with a relatively low risk of default, we see the most return potential in financials, which could benefit from interest-rate hikes. Financial companies also have the potential to adjust to higher inflation risks relative to other sectors in the market.
Among non-financials, we like BBB-rated corporate bonds; we are cautious on those with ratings of A or above, which tend to have longer-duration maturities and are more interest-rate sensitive. Investors should also be wary of companies with mergers and acquisitions risks, as corporates making changes to their capital structures may dilute valuations for bondholders.
High-Yield Bonds in Specific Sectors
Though absolute spread levels in high-yield bonds are close to being fully valued, relative valuations across sectors are reasonable. We prefer short-duration high-yield debt because it is less interest-rate sensitive vs. the broad index.
Our base case is that interest rates are rising but economic conditions should remain strong. Thus, default risks may stay low, and short-duration high-yield debt, including bank loans, are vehicles that can capture higher yield while potentially reducing interest-rate risk.
By rating cohort, we see value in single-B-rated bonds, viewed as a sweet spot in the high-yield universe because they have more spread or yield and less interest-rate sensitivity than BBs, with a higher credit quality than CCCs. Default risks may remain low and we believe single-Bs provide a good tradeoff between risk and return.
For opportunities to invest tactically and opportunistically, the sectors we prefer are:
- energy, should prices move higher,
- cable/media/broadcasting, though expect volatility in the near term and seek opportunities to buy at attractive valuations,
- retail, because of strong consumer fundamentals, and
- building materials, as demand for and prices of real assets may increase.
Securitized Credit as a Short-Duration Play
Securitized credit will remain compelling, too, as a short-duration asset class with respectable yields and solid credit fundamentals. Housing in both the U.S. and Europe remain well supported by price appreciation of the underlying assets and the credit quality of borrowers.
We are wary, however, of commercial real estate, but this varies greatly by sector. Agency mortgage-backed securities may also lose a tailwind from Fed purchases and cheapen in 2022.
Emerging-Market Debt and Currencies
After lagging in 2021, emerging-market debt has a lot of room for improvement this year. Central banks in emerging markets have been well ahead of developed markets in raising rates to stem inflation risks. If inflation stabilizes as we expect in 2022, then both local emerging-market debt and currencies stand to appreciate as global investors become attracted to the yield, carry and potential returns from this asset class.