3 Fixed-Income Opportunities Amid a Soft Landing

Mar 8, 2023

Some fixed-income assets could benefit from the Fed’s fight against inflation, including agency mortgage-backed securities and emerging-markets debt.

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Co-Author

Key Takeaways

  • The Federal Reserve’s ongoing fight against inflation could result in a soft landing in 2023.

  • Mortgage-backed securities, high-yield bonds and emerging-markets debt could benefit in this environment.

The Federal Reserve’s 2022 efforts to address skyrocketing inflation by tightening monetary policy was a key driver of asset prices, and that dynamic is likely to continue this year. One of the biggest questions for 2023 is: Will the Fed be successful in its attempt to keep inflation between 2% to 2.5%, while maintaining a balance between employment and price stability?

 

As the Fed has noted, rate hikes work, but there are often “long and variable lags” between changes in monetary policy action and their impact on the economy. Among the risks, Fed policy has the potential to erode U.S. corporate earnings, increase defaults, widen credit spreads and increase the chances of a recession. But after strong economic data releases and comments from the Fed in early 2023, the market is positioned for the Fed to continue to raise rates in the first half of 2023, albeit at a slower pace than in 2022. This will likely usher in a range-bound price action for U.S. Treasury bond yields, and with the labor market so tight it may be hard to have a deep recession.

 

A soft landing, in which the Fed can slow the economy and bring down inflation while avoiding recession, is becoming more and more possible. The labor market still seems pretty strong, which will likely keep credit default risks low on credit cards, autos and everything else. This environment also favors higher-beta fixed income, including asset-backed securities, high-yield bonds and emerging-markets debt. These are all sectors that would benefit from a more stable interest rate environment and a soft landing.

 

Three Fixed-Income Opportunities in 2023

If the Fed’s plan to durably stem inflation works, asset valuations may benefit over the longer term, offering several considerations for investors’ fixed-income portfolios.

 

  • Asset-backed securities: Particularly in agency mortgage-backed securities (MBS) and some securitized credit products, yield spreads (the difference in the rate of return between these assets and U.S. Treasuries) have stayed wide compared to high-yield and investment-grade issues. Investors may still want a little extra yield compared to Treasuries, which would make MBS and securitized credit products attractive and draw asset flows.

 

  • High-yield credit: Without a major recession on the horizon and with high-yield indexes yielding around 8-9%, there is ample room for yield spreads (the difference in the rate of return between high-yield bonds and Treasury bonds) to widen and still generate mid-single digit returns, if not higher. Moreover, it would also be highly unusual to have two years of negative high-yield returns in a row, after a -11% return in 2022.1

     

  • Emerging markets (EM) debt: We see EM debt as an attractive option for investors comfortable with a riskier asset class, particularly for debt issued in local currencies. While the U.S. dollar has started to weaken, it is still at very strong historical levels. If it continues to weaken in 2023, that would certainly be good for EM debt priced in non-dollar local currencies. Additionally, EM corporate debt—credit sectors—typically do well in a weak-dollar environment.

     

In sum, certain fixed-income assets could benefit in 2023 from a less aggressive Fed, a slowdown in the U.S. economy and improvements in various supply-side constraints.

 

The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results.  See Disclosure section for index definitions.

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