Discovering Sources of Alpha and Diversification in Fixed Income

In an economic environment characterized by rising interest rates and a forecasted slowdown, the fixed income asset class has emerged as a beacon of opportunity. Recently, Katie Klingensmith, Senior Vice President – Investment Strategist at Brandywine Global, moderated a panel of fixed income portfolio managers to explore these opportunities, discuss strategies to generate alpha and share their outlook as we approach the end of the year. Here are her key takeaways from this conversation.

As interest rates have moved higher, the fixed income asset class has been providing opportunities across a wide variety of sectors. I recently moderated a panel with fixed income portfolio managers to discuss options for investors to generate alpha as well as their outlook as we navigate through the end of the year and into 2024.

This panel discussion included Joshua Lohmeier, Portfolio Manager–Investment Grade, Franklin Templeton Fixed Income; Bill Zox, Portfolio Manager–High Yield, Brandywine Global; and Michael Buchanan, Co-Chief Investment Officer, Western Asset.

Here are my key takeaways from the discussion:

  • US growth headed for a slowdown. From a US economic perspective, all the panelists agreed that we are headed into a slowdown of gross domestic product growth, and the market’s projection of an outright recession has diminished. The US Federal Reserve’s (Fed’s) policies have pointed the economy toward a “soft landing,” but historically this outcome has been very difficult to achieve. Any slowing of growth will come with some pain and will be reflected in both US Treasury (UST) yields and credit spreads. The path of short-term interest rates, dictated by a still hawkish Fed, has led the US economy to a fragile point of high volatility where economic news can cause large changes to yields on a day-by-day basis. These conditions will likely continue over the next several quarters as the Fed assesses the long and variable lags that policy changes will have on less interest-sensitive sectors of the economy.
  • Continued strong corporate fundamentals. It was the consensus of the panelists that issuer fundamentals remain strong across the rating spectrum to support tighter credit spreads. Profit margins and revenues have been resilient as US economic growth and consumer spending continue to surprise on the upside. Additionally, corporate management teams took advantage of lower all-in yields available over the past several years to push back “maturity walls,” extending the period in which they will need to refinance debt and limiting the impact of rising rates on interest expenses for fixed-rate debt issuers. The benefits of extending maturities will be temporary as companies will still need to access capital markets in the future and be subject to prevailing interest rates at that time.
  • The return of higher income. UST yields at multi-decade highs have returned the power of income to the fixed income market. A large inversion of the UST curve throughout most of the year provided higher short-term UST bill yields compared to intermediate-maturity corporate bonds. This trend has led to a “buy T-bills and chill” attitude with investors feeling no reason to take risks to enhance returns. Rising intermediate UST yields combined with corporate bond spreads are now attractive on both yield and income bases. These enhanced yields can be locked when the bond is held to maturity. Higher yields also provide a buffer to total returns in a scenario of continued rising UST yields or if credit spreads were to widen.