Looking Back
During the summer months, the US yield curve bear steepened by 40 bps, pushing long-dated bond yields near post-pandemic highs. The move higher in rates was generally attributed to the following factors: 1) the downgrade of US Treasury debt by Fitch, 2) higher Treasury issuance to fund the fiscal deficit, 3) economic data that surprised to the upside, and 4) reduced demand from foreign buyers.
Looking Ahead
Following a quarter of surprisingly robust growth, we see a number of challenges, such as tight labor markets and sticky wages which may apply additional inflationary pressure forcing the Fed to keep rates higher for longer. Additionally, the resumption of student loan payments and higher gas prices could hinder the strength of the consumer. Over the coming months that may result in fading optimism over a soft landing. With these challenges and the current global economic backdrop, including Fed policy and economic uncertainty, we believe the opportunity set for fixed income is becoming more compelling today. Higher bond yields mean higher return expectations across the board. As discussed in the third quarter outlook, initial conditions matter. History has shown that the current yield has a very high correlation with the future return one receives on most fixed income investments. Another benefit of today’s high yields is the downside cushion they provide if interest rates were to rise further. Figure 1 displays the market implied probability of losses over the next 12 months for US Treasury bonds of varying maturities.*
Figure 1: Market Implied Probability of Negative Return USD/12M Horizon
* Calculated using the forward 1-year Treasury curve as the mean of the future rate distribution and 1-year volatility as the standard deviation of the future rate distribution. Probabilities of negative returns were then calculated using the future rate of distribution from the mean.
It is not possible to invest directly in an index. Please see disclosures for information related to comparisons to an index and index descriptions.
Past performance is not indicative of future results.
Source: Bloomberg and MacKay Shields. Data from January 1, 1997 to September 10, 2023
Based on today’s yield levels, even with elevated volatility, we maintain that the probability of a mark-to-market loss on short and intermediate maturity bonds is considerably lower than when yields where at post-pandemic lows, and lower than what we have been subject to for most of the past decade.**
** Not intended nor should be construed as an assurance of profit or a guarantee against loss. There are inherent risks in any investment.
Approach: Guidance
Duration
Modest long duration bias as we believe interest rates are at or near cycle peaks
Yield Curve
Inverted yield curve = favor short - intermediate maturities
Spreads
Up in quality
Volatility
Rates volatility to gradually normalize
Asset Allocation
Favor agency mortgages, and select portions of the commercial mortgage-backed securities (CMBS) market
Periods of elevated bond market volatility create pockets of dislocation across segments of the market. Looking at the current fixed income landscape, while yields are very high today (Figure 2), valuations, as represented by spreads over risk-free US Treasuries are at or near historical averages. However, there are some exceptions. In particular, AAA-rated agency mortgage-backed securities are at their highest yields and widest spreads in more than a decade. The reasons: lack of new supply as housing has become much less affordable, Quantitative Tightening by the Federal Reserve has removed a major source of demand for mortgage-backed securities and forced selling by the FDIC as they liquidate the portfolios of seized banks (e.g., Silicon Valley Bank). These events have converged to form a perfect storm that has driven spreads much wider and in our view has created today’s opportunity for patient investors.
Looking ahead, in the US and in Europe, attention will increasingly shift from how high central banks will take interest rates to how long rates will remain at elevated levels. With growth still strong in the US, it is premature to expect a shift in policy from the FOMC. Chair Powell made clear in his Jackson Hole speech that the Fed is resolute about getting to its 2% target. The latest Fed meeting served to reinforce the “higher for longer” narrative when they published the latest forecasts where they appear to be extrapolating stronger than expected growth and that the neutral rate of interest is higher than previously thought, and will decline more gradually. The ECB faces a more delicate balance as growth is already weak in Europe and inflation remains stubbornly high, albeit well off its peaks. While further hikes can’t be ruled out, we may begin to see greater focus on growth from the ECB so long as disinflationary trends continue.
Figure 2: Bond Yields Near 10-Year Highs Across Credit Markets
Yield-to-worst is a measure of the lowest possible yield that can be received on a bond that fully operates within the terms of its contract without defaulting.
Corporates = Bloomberg US Corporate Bond Index; High Yield = Bloomberg US Corporate High Yield Bond Index; Agency RMBS = Bloomberg US Mortgage Backed Securities (MBS) Index; CMBS = ICE US Fixed Rate Non-Agency CMBS Index; Taxable Municipal = Bloomberg Taxable Municipal Index Index; Emerging Markets = ICE BofA US Emerging Markets External Debt Sovereign & Corporate Plus Index.
Source: Bloomberg, ICE Data.
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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. ©2023, MacKay Shields LLC. All Rights Reserved.
MacKay Shields LLC is a wholly owned subsidiary of New York Life Investment Management Holdings LLC, which is wholly owned by New York Life Insurance Company. "New York Life Investments" is both a service mark, and the common trade name of certain investment advisers affiliated with New York Life Insurance Company. Investments are not guaranteed by New York Life Insurance Company or New York Life Investments.
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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.
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.
INDEX DESCRIPTIONS
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.
Bloomberg US Corporate Total Return Value Unhedged USD
The Bloomberg US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by US and non-US industrial, utility and financial issuers
Bloomberg BAA US Corporate Index
The Bloomberg Baa Corporate Index measures the Baa-rated, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by US and non-US industrial, utility and financial issuers.
Bloomberg US Taxable Municipal Bond Index
The Bloomberg U.S. Taxable Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term taxable bond market. To be included in the index, bonds must be rated investment-grade (Baa3/BBB- or higher) by at least two of the following ratings agencies if all three rate the bond: Moody's, S&P, and Fitch. If only two of the three agencies rate the security, the lower rating is used to determine index eligibility. If only one of the three agencies rates a security, the rating must be investment-grade. They must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The bonds must be fixed rate and must be at least one year from their maturity date. Remarketed issues (unless converted to fixed rate), bonds with floating rates, and derivatives, are excluded from the benchmark.
Bloomberg US Corporate High Yield Total Return Index Value Unhedged USD
A component of the US Corp High Yield Index that is designed to track a more liquid component of the USD-denominated, high yield, fixed-rate corporate bond market. The US High Yield VLI uses the same eligibility criteria as the US Corp High Yield Index, but includes only bonds that have a minimum amount outstanding of USD500mn and less than five years from issue date.
Bloomberg Pan-European Aggregate Index
Covers eligible investment grade securities from the entire European continent. The primary component is the Bloomberg Euro-Aggregate Index. In addition, the Bloomberg Pan-European Aggregate Index includes eligible securities denominated in British pounds (GBP), Swedish krona (SEK), Danish krone (DKK), Norwegian krone (NOK), Czech koruna (CZK), Hungarian forint (HUF), Polish zloty (PLN), Slovenian Tolar (SIT), Slovakian koruna (SKK), and Swiss franc (CHF). Apart from the currency constraint, the inclusion rules for the Pan-European Index are identical to those of the Bloomberg Euro-Aggregate Index.
Bloomberg Non-Agency Investment Grade CMBS Index
The Bloomberg Non-Agency Investment Grade CMBS Index measures the market of conduit and fusion CMBS deals with a minimum current deal size of $300 million that are rated investment grade or higher using the middle rating of Moody's, S&P, and Fitch after dropping the highest and lowest available ratings.
J.P. MORGAN EMBI GLOBAL DIVERSIFIED INDEX
The J.P. Morgan EMBI Global Diversified Index (EMBIG) tracks liquid, US Dollar emerging market fixed and floating-rate debt instruments issued by sovereign and quasi-sovereign entities.
J.P. Morgan CEMBI Broad Diversified Core Index
The J.P. Morgan CEMBI Broad Diversified Core Index (CEMBI CORE) tracks the performance of US dollar-denominated bonds issued by emerging market corporate entities.
“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.
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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“New York Life Investments” is both a service mark, and the common trade name, of certain investment advisors affiliated with New York Life Insurance Company.
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