Investment grade strategies for the second half of year

Key drivers of US financial markets in the first half of this year centered on inflation and Federal Reserve (Fed) policy. There’ve been some ups and downs with inflation, but recent data suggest that it’s declining toward the Fed’s 2% target and that rate cuts are on the horizon. There’s now an increased focus on US growth dynamics. We answer questions about what this shift may mean for investment grade bonds and our strategy for navigating the second half of the year.

Q: What do you expect for inflation and interest rates going forward?

Matt: The first half of the year was interesting. For several months, all eyes were on the Fed and other central banks as markets gauged the possibility of rate cuts. But by April, everyone threw in the towel and decided cuts were probably not going to happen this year. The second they did this, we started getting better inflation data in the US and globally. This allowed the European Central Bank (ECB) to cut rates, along with the Bank of Canada. So, US friends and neighbors are cutting interest rates, but the US isn’t, though we believe cuts are on the way.

The market’s focus has shifted from inflation to growth. Growth is clearly slowing, though not sharply, and we’re seeing it in the consumer and other spots in the economy. This makes us more comfortable that inflation is on a downward path. Inflation prints will continue to moderate, in our view, driven by a slowdown in goods inflation — and perhaps deflation. Services and shelter prices may continue to be a challenge, but we believe they’ll also moderate, and that we’ll see two rate cuts before the end of the year.

Q: Do you expect increased flows into investment grade once the Fed starts cutting rates?

Todd: There’s still a tremendous amount of money sitting in cash in the US — around $6 trillion in money market accounts.¹  There’s a lot of cash in Canada on the sidelines as well, and these two yield curves are still inverted. So as the Fed and Bank of Canada cut rates, we think people will start looking at their bank statements and realize that they aren’t getting that 5% on their cash anymore. They’ll probably start to lock in some of that at a higher rate in investment grade. In the US, fund flow data suggest that’s already happening.² Japanese investors may also be attracted to the US investment grade market if currency hedging costs improve, as the Fed cuts rates while the Bank of Japan hikes rates. Traditional fixed income demand from insurance companies and pension funds also remains strong.

Q: Market technicals refer to supply and demand for investment grade. You just described the demand side — what do you expect for supply?

Todd: We’ve definitely seen a tremendous amount of supply, over $800 billion³ in our marketplace this year. That represents a 30% to 40% year-over-year increase in bond issuance. But it’s important to note that yields have been much lower this year than last fall when corporate treasurers and chief financial officers were weighing the market. The financing environment has been ripe. Companies likely wanted to lock in financing and avoid the potential volatility that might pick up later this year with the US elections. The new issues were well absorbed and have performed well, with credit spreads tighter on the year.

We expect supply to slow in the second half of the year because it started out front-loaded. Also, we don’t expect a heavy new issue calendar going forward. Large merger and acquisition deals don’t appear on the horizon and the leveraged buyout market has been quiet. We also expect supply to slow in several sectors, such as financial firms, which were large issuers in the first half of the year. This should all promote supply and demand balance, favoring investors.

Q: Turning to investment strategy, how do you plan to navigate the rest of the year?

Matt: Looking back at the start of the year, we didn’t buy the argument that there’d be a massive slowdown in the US economy. We also didn’t buy into the fears that US banks would be in serious trouble. We had a more favorable outlook, which led us to overweight positions in corporate credit and higher-spread assets. They tend to do well when the economy does well. While the economy is slowing, it’s still doing well. As the market shifts its focus from concerns about inflation to concerns about growth, we now favor dialing back risk somewhat. That’s especially since credit spreads have narrowed and valuations may not look as attractive as they did earlier in the year.

Todd: The market is more fairly priced now, in our view, after previously being mispriced for a recession.  The more than 5% yield on the investment grade index is still compelling, on a historical basis.⁴  We think most of an investor’s total return is likely to come from the coupon this year. We could see some volatility, but we’re looking forward to taking advantage of any softness this summer. We anticipate potential opportunities in the fall, especially as the new issue calendar resumes. In the meantime, we see some attractive yield opportunities in short-dated asset-backed securities, certain non-agency mortgage-backed securities, and AAA-rated collateralized loan obligations, as we wait for future opportunities to take on more risk.