At the most recent FOMC meeting, central bank policy makers communicated that the string of recent firm inflation prints have not fundamentally changed their outlook for inflation or monetary policy.
The rate market is pricing in 50 basis points of cuts during the latter half of the year, consistent with the FOMC dot plot projections. The credit markets are not pricing in a contraction of growth.
Although headline pricing across most sectors of the fixed income market appear rich, beneath the surface a very different story exists across industries, capital structures and sectors.
Key Invetsment Themes
- Maintain a longer duration bias relative to most benchmarks;
- Overweight banks, underweight industrials;
- Overweight higher coupon Agency mortgages, underweight lower coupons;
- Overweight select commercial mortgage securities;
- Overweight subordinated consumer ABS;
- Overweight higher quality high yield, underweight stressed/distressed; and
- Overweight hard currency emerging markets sovereigns, underweight corporates
Duration— Remaining Invested Should Benefit
We believe we are at or near the peak cycle in interest rates and that the next move will be a move lower in rates, led by the front-end of the curve. We expect the yield curve to steepen modestly with a positive slope emerging over the balance of the year.
Bigger Is Better, but Smaller Can Offer Value in Banking
The banking sector continues to trade wide relative to the rest of the corporate market. At the root of it lies commercial real estate and an inverted yield curve that has reduced lending activity and squeezed net interest margins. Recent banking troubles have not been broadly systemic. As the commercial property market cycle plays out and the yield curve renormalizes, banks will work with borrowers to restructure loans. The performance of individual banks will ultimately depend on their size, loan mix and profitability.
Figure 1: Ratio of Financial to Industrial OAS
Data as of March 29, 2024
Option-adjusted spread
Dashed line = Median (monthly data from April 2014 to March 2024)
Source: ICE Data
Higher Coupon over Lower Coupon
In the Agency mortgage market, higher coupon securities are trading with wider spreads, lower durations, higher yields and better liquidity than lower rated investment grade corporates.
Figure 2: Current Coupon MBS and Corporates 5-10 A or Higher
Data as of March 29, 2024
Source: Bloomberg
Leaning into Mortgage Credit Via Credit Risk Transfers
The Credit Risk Transfer (CRT) market, which was created by the agencies as a way to reduce their credit exposure to borrowers, was one of the top performing sectors of the bond markets in 2023. We expect spreads to continue to grind tighter, particularly on subordinate deals with elevated home price appreciation (HPA).
Figure 3: CRT B1 to HY BB
Data as of March 29, 2024
Source: ICE Data
Not All Commercial Real Estate Is the Same
Commercial real estate is expected to remain under pressure for the next few years. Debt securities tied to the commercial property market, particularly lower quality deals, are offered at distressed levels. Not all commercial real estate is alike and the same holds true for the securitization market. For example, Class A properties with strong credit support, good sponsorship and high-quality tenants are in a much better position than other office properties.
Figure 4: Despite the Recent Rally, CMBS Spreads Can Offer Value for Selective Investors
Data as of March 29, 2024
Source: Bloomberg
Betting on the Consumer through the ABS Market
In our view, the gap between the spreads of subordinated consumer credit and senior debt has room for further narrowing. This is partly due to banks tightening their lending criteria and raising interest rates, which, in turn, enhances credit quality. Given these conditions, we find it appealing to invest down in quality in the ABS market.
Figure 5: ABS Can Offer Attractive Value Relative to Corporates
Data as of March 28, 2024
Source: ICE Data
Staying Up in Quality
We believe it will be difficult for CCCs to continue their strong performance in 2024 versus the higher quality part of the market. There is a deteriorating credit trend among CCC issuers relative to the rest of the high yield market, as seen in the chart below. Despite a resilient economy, higher interest rates are weighing on the lowest quality issuers, creating a significant headwind to further upside.
Figure 6: # of Issuer Upgrades and Downgrades YTD as of December 2023
Data as of December 31, 2023
Source: ICE Data
Emerging Markets begin to Shine
We believe Emerging Market (EM) hard currency debt presents an attractive opportunity, buoyed by historically appealing yields and a positive start to the year despite higher US interest rates. The asset class has benefited from a compression of credit spreads, particularly aiding lower-rated issuers, indicating a robust appetite among investors for higher yields amidst a supportive commodity price environment. With EM economic growth outpacing expectations and fears of recession in developed markets receding, the outlook for EM debt is bolstered by the anticipation of a more favorable global interest rate environment. Despite potential volatility from a busy electoral calendar, the compelling yield advantage, coupled with a supportive economic backdrop, underscores a strong case for EM.
Figure 7: Emerging Market USD Sovereign Can Offer Attractive Risk-Reward
Data as of March 28, 2024
Source: Bloomberg and JP Morgan
IMPORTANT DISCLOSURE
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This material contains the opinions of certain professionals at MacKay Shields but not necessarily those of MacKay Shields LLC. The opinions expressed herein are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and opinions contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Any forward-looking statements speak only as of the date they are made and MacKay Shields assumes no duty and does not undertake to update forward-looking statements. No part of this document may be reproduced in any form, or referred to in any other publication, without express written permission of MacKay Shields LLC. ©2024, MacKay Shields LLC. All Rights Reserved.
Information included herein should not be considered predicative of future transactions or commitments made by MacKay Shields LLC nor as an indication of current or future profitability. There is no assurance investment objectives will be met.
Past performance is not indicative of future results.
RISKS OF INVESTING IN ASSET AND MORTGAGE-BACKED SECURITIES
One of the principal risks of mortgage-related and asset-backed securities is that the underlying debt may be prepaid ahead of schedule if interest rates fall, thereby reducing the value of an investment. If interest rates rise, there is less prepayment risk but defaults may increase, potentially causing losses. This is not a complete list of risks associated with the strategy. Consult your professional advisors for further guidance.
COMPARISONS TO AN INDEX
Comparisons to a financial index are provided for illustrative purposes only. Comparisons to an index are subject to limitations because portfolio holdings, volatility and other portfolio characteristics may differ materially from the index. Unlike an index, individual portfolios are actively managed and may also include derivatives. There is no guarantee that any of the securities in an index are contained in any managed portfolio. The performance of an index may assume reinvestment of dividends and income, or follow other index-specific methodologies and criteria, but does not reflect the impact of fees, applicable taxes or trading costs which, unlike an index, may reduce the returns of a managed portfolio. Investors cannot invest in an index. Because of these differences, the performance of an index should not be relied upon as an accurate measure of comparison.
SOURCE INFORMATION
ICE DATA INDICES, LLC (“ICE DATA”), IS USED WITH PERMISSION. ICE® IS A REGISTERED TRADEMARK OF ICE DATA OR ITS AFFILIATES, AND BOFA® IS A REGISTERED TRADEMARK OF BANK OF AMERICA CORPORATION LICENSED BY BANK OF AMERICA CORPORATION AND ITS AFFILIATES ("BOFA") AND MAY NOT BE USED WITHOUT BOFA'S PRIOR WRITTEN APPROVAL. ICE DATA, ITS AFFILIATES AND THEIR RESPECTIVE THIRD PARTY SUPPLIERS DISCLAIM ANY AND ALL WARRANTIES AND REPRESENTATIONS, EXPRESS AND/OR IMPLIED, INCLUDING ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, INCLUDING THE INDICES, INDEX DATA AND ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM. NEITHER ICE DATA, ITS AFFILIATES NOR THEIR RESPECTIVE THIRD PARTY SUPPLIERS SHALL BE SUBJECT TO ANY DAMAGES OR LIABILITY WITH RESPECT TO THE ADEQUACY, ACCURACY, TIMELINESS OR COMPLETENESS OF THE INDICES OR THE INDEX DATA OR ANY COMPONENT THEREOF, AND THE INDICES AND INDEX DATA AND ALL COMPONENTS THEREOF ARE PROVIDED ON AN “AS IS” BASIS AND YOUR USE IS AT YOUR OWN RISK. ICE DATA, ITS AFFILIATES AND THEIR RESPECTIVE THIRD PARTY SUPPLIERS DO NOT SPONSOR, ENDORSE, OR RECOMMEND MACKAY SHIELDS LLC, OR ANY OF ITS PRODUCTS OR SERVICES.
“Bloomberg®”, “Bloomberg Indices®”, Bloomberg Fixed Income Indices, Bloomberg Equity Indices and all other Bloomberg indices referenced herein are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the indices (collectively, “Bloomberg”) and have been licensed for use for certain purposes by MacKay Shields LLC (“MacKay Shields”). Bloomberg is not affiliated with MacKay Shields, and Bloomberg does not approve, endorse, review, or recommend MacKay Shields or any products, funds or services described herein. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to MacKay Shields or any products, funds or services described herein.
The following indices may be referred to in this document:
BLOOMBERG U.S. AGGREGATE BOND INDEX
The Bloomberg U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. Must have at least one year to final maturity regardless of call features. Must have at least $300 million par amount outstanding. Must be rated investment-grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody's, S&P, Fitch. Must be dollar-denominated and non-convertible.
ICE BOFA U.S. CORPORATE INDEX
Tracks the performance of U.S. dollar denominated investment grade corporate debt publicly issued in the U.S. domestic market.
ICE BOFA U.S. HIGH YIELD INDEX
ICE BofA U.S. High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market..
ICE BOFA US MORTGAGE BACKED SECURITIES INDEX
ICE BofA US Mortgage Backed Securities Index tracks the performance of US dollar denominated fixed rate residential mortgage pass-through securities publicly issued by US agencies Fannie Mae, Freddie Mac and Ginnie Mae in the US domestic market. 30-year, 20-year and 15- year fixed rate mortgage pools are included in the Index provided they have at least one year remaining term to final maturity and a minimum amount outstanding of at least $5 billion per generic coupon and $250 million per production year within each generic coupon.
BOFA US FIXED RATE CMBS INDEX
BofA US Fixed Rate CMBS Index tracks the performance of US dollar denominated investment grade fixed rate commercial mortgage backed securities publicly issued in the US domestic market.
ICE BOFA AA-BBB US ASSET BACKED SECURITIES INDEX
Represents the portion of the ICE BofA US Fixed Rate Asset Backed Securities Index composed solely of bonds that are rated AA-BBB.
ICE BOFA HIGH YIELD EMERGING MARKETS CORPORATE PLUS INDEX
ICE BofA High Yield Emerging Markets Corporate Plus Index is a subset of The ICE BofA Emerging Markets Corporate Plus Index including all securities rated BB1 or lower. ICE Bank of America High Yield Master II Index tracks the performance of US dollar denominated below investment grade rated corporate debt publically issued in the US domestic market. To qualify for inclusion in the index, securities must have a below investment grade rating (based on an average of Moody's, S&P, and Fitch) and an investment grade rated country of risk (based on an average of Moody's, S&P, and Fitch foreign currency long term sovereign debt ratings). Each security must have greater than 1 year of remaining maturity, a fixed coupon schedule, and a minimum amount outstanding of $100 million.
ICE BOFA EMERGING MARKETS EXTERNAL SOVEREIGN INDEX
ICE BofA Emerging Markets External Sovereign Index tracks the performance of US dollar and euro denominated emerging markets sovereign debt publicly issued in the major domestic and eurobond markets.
DEFINITIONS
Active Management: Active management is the use of a human element, such as a single manager, co-managers or a team of managers, to actively manage a fund’s portfolio. Active management strategies typically have higher fees than passive management.
Duration: Duration can measure how long it takes, in years, for an investor to be repaid a bond’s price by the bond’s total cash flows.
Spreads: The difference of gap that exists between two prices, rates, or yields.
Yield Curve: A line that plots yields of bonds having equal credit quality but different maturity dates.
NOTE TO UK AND EUROPEAN AUDIENCE
This document is intended only for the use of professional investors as defined in the Alternative Investment Fund Manager’s Directive and/or the UK Financial Conduct Authority’s Conduct of Business Sourcebook. To the extent this document has been issued in the United Kingdom, it has been issued by MacKay Shields UK LLP, 80 Coleman Street, London, UK EC2R 5BJ, which is authorised and regulated by the UK Financial Conduct Authority. To the extent this document has been issued in the EEA, it has been issued by MacKay Shields Europe Investment Management Limited, Hamilton House, 28 Fitzwilliam Place, Dublin 2 Ireland, which is authorised and regulated by the Central Bank of Ireland.
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