While the prevailing narrative suggests that these fiscal challenges may fuel interest rate volatility throughout the year, we find ourselves at a juncture where rising term premia indicate that the market has already largely factored in the deteriorating supply outlook. The outcome of the 2024 US Presidential election is a pivotal variable to watch. Amidst these dynamics, we view current yield levels as laying the foundation for robust fixed income returns for the foreseeable future. Moreover, there are distinct opportunities that merit attention. Emerging markets debt beckons with potential, offering a fresh avenue for investors seeking growth across corporate, hard currency sovereign and local currency debt. Closer to home, Agency mortgage-backed securities (MBS) stand as a compelling choice, boasting higher yields than investment-grade corporate debt while, in our view, carrying negligible credit risk. In addition, significantly higher mortgage rates have notably mitigated prepayment risk, reinforcing Agency MBS as an attractive proposition. Meanwhile, high-yield corporate bonds continue to hold appeal within the higher echelons of credit quality. Lower-rated CCC debt took center stage in 2023. However, deteriorating credit trends suggest that a repeat performance is unlikely.
1. Economics Trumps Treasury Supply
Against a backdrop of long-simmering concerns over US debt sustainability, we expect the outlook for deficits and supply to remain a driver of rate market volatility in 2024, especially around quarterly refunding announcements and longer-dated Treasury auctions. Federal Reserve policy may also contribute to investor hand-wringing over the supply picture, as the central bank’s ongoing quantitative tightening operations, or balance sheet run-off of Treasuries and MBS, will add additional supply back into the market likely through the first half of next year. Treasury will also need to offset via issuance the loss of income on the Federal Reserve’s securities portfolio, as the central bank continues to fund low-yielding assets with expensive bank reserves. This later dynamic may remain in place for several more years.
Treasury Coupon Issuance, Actual and Forecast
Source: US Treasury Department, Bank of America
Still, we believe that any market volatility related to fiscal news may ultimately prove limited, at least in 2024. First, estimates of the Treasury term premium have risen notably in recent months, suggesting that a worsening supply outlook may already be largely discounted. In addition, we expect some factors that drove the significant increase in the fiscal year 2023 deficit will not repeat, namely, the inflation adjustment to social security outlays and weak capital gains tax revenues. Further, the growth slowdown we anticipate next year should put downward pressure on rates. We suspect this will be a more significant driver of fixed income markets, especially as moderating inflation will open the door to less restrictive monetary policy. Finally, the Treasury Department has already demonstrated sensitivity to market concerns over the supply picture, limiting the increase in long-term Treasury auction sizes in the most recent refunding announcement. We suspect Secretary Yellen will continue with this more flexible approach, within the context of regular and predictable issuance.
One important caveat to our views revolves around the presidential election, and the potential that former President Trump returns to office. This scenario could precipitate a material rise in yields and volatility, as a Trump presidency – especially if it coincides with Republican control of Congress – would dampen any move toward entitlement reform, raise market expectations that the 2017 tax cuts would be extended, and increase the odds that corporate tax increases in the Inflation Reduction Act would be eliminated. Progress on fiscal reform, while clearly not a priority today, would surely be kicked further down the road.
2. Bonds Outperform Equities
In assessing the potential of investment returns, starting levels of bond yields and equity multiples are very good indicators of potential returns over a medium term horizon. At present, bond yields are at or near the highest levels since before the Global Financial Crisis. On average, these yields have historically led to outperformance over medium to longer term horizons. This contrasts with current equity valuations, as indicated by the Shiller cyclically-adjusted price/earnings (CAPE) ratio, which historically correlates with underperformance when at current levels.
Equities Expensive Based on CAPE
Moreover, the consistency of returns from bonds is noteworthy. Data illustrates a more stable distribution of bond returns compared to equities, enhancing the appeal of fixed income investments. A historical perspective reinforces this view: in the last century, only a few instances, such as during the Great Depression and the dot-com crash, have seen U.S. equities outpacing bonds with yields and multiples at or near current levels.
Current Valuations Favors Bonds Over Stocks
Source: Bloomberg, Shiller date: http://www.econ.yale.edu/~shiller/data.htm, MacKay Shields; Bonds represented by the Bloomberg US Government/Corporate Bond Index from Jan 1973 to Jan 1976 and the Bloomberg US Aggregate bond index from Feb 1976 to Oct 2023. Stocks represented by the S&P 500.
Another key metric we look at is the equity risk premium (ERP), which we calculate as the earnings yield or the inverse of the S&P 500’s price/earnings ratio, minus the yield of the 10-year U.S. Treasury note. Currently, the ERP hovers slightly over 1%, a figure comparable to the lows of 2007. This suggests that equity valuations, in relation to bonds, are at an unusually high level, unlikely to be sustained in the long term. This scenario presents a compelling case for prioritizing fixed income over equity in multi-asset portfolios.
Given today’s yield levels, we advocate for a stronger focus on fixed income, even when considered independently of equity valuations. Not only does fixed income present attractive return potential, but, in our view, it also offers a buffer in portfolio performance during market downturns, particularly as current dis-inflationary trends persist.
3. Emerging opportunities in Developing Market Debt
From a total return perspective, we believe current yield levels across Emerging Market debt sub-asset classes offer significant positive potential for 2024. As we always advocate, country and issuer selection remain paramount to investment success, and we detect trends of divergence within each sub asset class.
Emerging Market Yields Offer Notable Opportunity
Source: JP Morgan.
For Emerging Market Hard Currency Corporates, we favor defensive sectors over cyclical sectors. Furthermore, TMT companies (Technology, Media & Telecommunications) in Latin America are facing a tough competitive landscape and a challenging growth stagnation trend going forward. We are also cautious on the Petrochemical sector across regions due to large supply emanating from China, depressing margins for this industry worldwide. Utilities should continue to do well as a defensive sector, and we especially like the Indian renewable energy sector, which remains in growth mode and is well aligned with the Indian government’s clean energy transition objectives. Another area of opportunity, the Macao gaming industry continues to benefit from positive structural changes. The industry has shifted its focus from junket operators to one of premium mass market with higher profit margins. It has also successfully diversified its revenues by expanding into entertainment and attracting a new segment of consumers that are younger and more social media savvy, in addition to the well-established, traditional casino consumers.
Source: JP Morgan.
Within Emerging Market Hard Currency Sovereigns, while Investment Grade spreads are not particularly appealing to us, there are selective value opportunities in High Yield sovereigns, where we think markets are too pessimistic on default probabilities. Similarly, within Emerging Market Local Currency Sovereigns, we believe high yielders in Latin America and Europe should outperform amid easing inflation and attractive term premia. However, low yielders in Asia may struggle, facing tight interest rate differentials against the US and slower disinflation prospects.
We believe for Emerging Market debt, the theme of divergence across asset classes, regions, countries and sectors will be prevalent, which provides abundant investment opportunities for 2024.
4. Lock in Mortgages in 2024
The attractiveness of U.S. Agency Mortgage-Backed Securities (MBS) is underscored by a convergence of monetary policy shifts and market dynamics. The Federal Reserve's move away from quantitative easing and its rate hikes have significantly widened the spread of Agency MBS over U.S. Treasuries. This shift, along with high interest rates and a cooling housing market, has greatly mitigated prepayment risks, enhancing the appeal of Agency MBS in the fixed-income market.
A notable factor in this landscape are the market technical pressures related to the banking sector. The FDIC's completion of the sales of Agency MBS from the portfolios of Silicon Valley Bank and Signature Bank has alleviated some market pressure, potentially ushering in a period of more stable MBS pricing. There remains approximately $3 billion of Agency CMO’s that are still to be sold, but we expect these sales to be completed by the end of this year. However, bank demand for MBS has been notably weak, a trend that might see a turnaround should market volatility stabilize. Bank demand may also resurface as loan demand cools in a slowing economy. This potential increase in bank demand for MBS could provide further support to the market, making Agency MBS an even more attractive investment.
Contrasting this with the investment grade corporate bond market, spreads recently touched new lows for the year, not adequately reflected the broader economic slowdown, heightened market volatility, and geopolitical risks. This disconnect suggests that corporate bonds may not be fully pricing in the prevailing economic uncertainties. In contrast, Agency MBS, with their higher yields, wider spreads and reduced prepayment risks, appear to offer a more accurate reflection of the current economic environment. This makes them a particularly appealing option for investors seeking stability and yield in an uncertain market. With the technical headwinds from banking sector challenges easing and the prospect of renewed bank interest in MBS, Agency MBS are poised to be a key investment choice, offering both relative safety and potential for superior performance in the coming year.
Mortgage-Backed Securities Poised to Outperform
Source: Bloomberg and MacKay Shields as of November 24, 2023. MBS yield reflects the yield on FNMA currency coupon MBS, Corporate Yield is represented by the yield to worst on the Bloomberg US Corporate 5-10 Year Index of A or higher credit quality; MBS CC Spread is the currency coupon yield minus the average yield on a 5-year and 10-year US Treasury and the Corp OAS is the option-adjusted spread of the Bloomberg US Corporate 5-10 Year Index of A or higher credit quality.
5. Stressed Credits Fall Out of Favor
At the beginning of 2023, few would have predicted that CCC-rated bonds would have their best year since 2016. As of November 30, 2023, the CCC segment of the ICE BofA US High Yield Index has returned a remarkable 13.7%.
However, we believe it will be difficult for CCCs to continue their strong performance in 2024 versus the higher quality part of the market.
As shown in the chart below from JP Morgan, the “upgrade-to-downgrade” ratio for the high yield market remains above one (i.e. for every $1 of high yield bonds downgraded by credit rating agencies, $1.3 in high yield bonds were upgraded). While this ratio has declined sharply from the 2021 high, it suggests that broad credit trends remain stable.
Last 12 Months US HY Upgrade to Downgrade Ratio (by Par)
As of September 30, 2023
Source: JP Morgan.
Beneath the surface, however, there is a stark difference in credit trends between CCC issuers and the rest of the high yield market. As seen in the chart below, so far in 2023 the number of CCC issuers downgraded (65) have significantly outnumbered the number upgraded (38). On the other hand, both BB and B issuers have continued to more frequently experience upgrades than downgrades.
Number of Issuer Upgrades and Downgrades YTD to September 2023
As of September 30, 2023
Source: JP Morgan.
It is important to note that CCCs represent only 11% of the market, and we believe the credit outlook for high yield remains strong. The quality of high yield bonds has improved significantly in the past decade. The ICE BofA US High Yield Index is now comprised of 51% BBs (on a par value basis) at the end of 2022, up from 43% at the end of 2011. High yield issuers today are generally publicly traded companies - 69%, according to JP Morgan. Even if the US economy heads into a recession, it is unlikely that default rates spike far above historical norms.