Markets today reflect a push and pull between optimism and pessimism, presenting opportunities for income in unexpected places.Getty Images
Income-oriented strategies have made a dramatic comeback in the past year after plenty of downside drama in 2022, and through much of 2023, both of which were marked by high inflation and rising interest rates.
“There’s been a lot of positive sentiment recently… not just for fixed income but for equities, too,” says David Wong, chief investment officer for total investment solutions at CIBC Asset Management in Toronto.
Bonds have benefited from the Bank of Canada and the U.S. Federal Reserve cutting interest rates, further bolstered by the anticipation of more reductions as the prospect of a soft landing for the U.S. economy seems more realistic.
Financial, utilities and real estate stocks – all dividend producers – have also performed well, Mr. Wong adds.
“That’s very unusual” because these value stocks have “underperformed the market for 14 years,” and their recent results suggest investors believe “a rate pivot” is at hand, says Mr. Wong, co-portfolio manager of the CIBC U.S. Dollar (Hedged) Managed Income Portfolio – Class A, winner of this year’s Canadian Fixed Income Balanced Lipper Award.
“Unusual” is a good description of the current environment, but the pivot is not merely a juncture where interest rates will trend downward smoothly from here, which is often a tailwind for bonds and equities alike. Rather, markets today reflect a push and pull between optimism and pessimism, presenting opportunities for income in unexpected places.
Mr. Wong describes part of the current struggle as one of enticing income investors, who were burned by rising interest rates and flocked to the safety of GICs (guaranteed investment certificates), off “the sidelines” and back into strategies that adjust with a changing environment.
“We’re still in the early days, but it’s time to get out of the risk curve again,” Mr. Wong says about bonds with increasing duration and even dividend paying equities.
He further notes the yield curve is no longer inverted – considered a harbinger of market doom. Still, the curve remains inverted at the short end for maturities of one year and less.
It’s a situation that partly reflects the uncertainty about the direction of the Fed, inflation and the economy, says Eric Mollenhauer, Boston-based portfolio co-manager of the Fidelity Floating Rate High Income Fund – Series F.
The fund won this year’s Lipper Fund Award for Floating Rate Funds, a strategy that outperformed traditional income funds in 2022 and 2023, and continues to perform well this year. “If short rates fall, that will definitely eat into our performance,” he says.
Yet the direction of interest rates is not set in stone. “I’ve been running this fund since 2007 and everybody asks: ‘What do you think is going to happen with rates?’ and my answer is, ‘I have no clue.’”
Mr. Mollenhauer points to earlier this year as an example. The general consensus was the Fed would cut rates significantly by the end of 2024, which has yet to come true.
“Now, it feels like we might see higher short-term rates for longer.”
This in-between period can augur well for more esoteric income investments, including leveraged loans, he adds. This lesser-known class of fixed income has been a focus of Fidelity’s fund management team because these loans generally have wider spreads over safe assets when compared with corporate bonds. Yields in the space for companies with strong fundamentals are about 400 basis points higher than risk-free, short-term U.S. treasuries, Mr. Mollenhauer says, versus the spread for investment grade at about 100 basis points.
Spreads are also attractive for mortgage-backed securities in the United States. “Typically, the spreads on mortgage-backed securities are lower than the spreads on investment grade,” says Alfred Murata, co-lead portfolio manager of the PIMCO Monthly Income Fund – Series F (Hedged), which won the Multi-Sector Fixed Income Lipper Fund Award this year.
That’s particularly true for agency mortgage-backed securities, guaranteed by government-sponsored enterprises such as Fannie Mae and Freddie Mac.
Spreads for these AAA assets have widened as their traditional investors – banks and the Fed – have pulled back.
In turn, their average spreads over risk-free treasuries have widened from a historical norm of about 75 to 140 basis points. At the same time, investment-grade credit spreads have shrunk from about 125 basis points to 85 basis points, he says.
Should interest rates remain steady or even move higher, Mr. Murata says mortgage-backed securities will still provide a good yield. As the Fed cuts and long-term rates come down, agency mortgage-backed securities should see spreads tighten, benefiting prices, he notes.
“Today, we have the unusual phenomenon where we are relatively constructive for the macroeconomic outlook, and yet, we have de-risked the portfolio from a credit perspective,” says Mr. Murata, based in Newport Beach, Calif. “The reason is because we’re finding higher yields in these high quality assets.”
While short-term volatility and uncertainty present opportunity, yields for most income assets are higher today than they have been in more than a decade and could be as good as they get for the foreseeable future, Mr. Wong says.
“The number one marker of return long-term for fixed income is starting yield.” He adds that this is a good focus for investors because starting yield is “highly connected” with expected returns for the coming decade, pointing to the performance of the Canadian 10-year bond index. Over the past decade, its annualized return was 2.2 per cent while its starting yield 10 years ago was 2.28 per cent, Mr. Wong says.
“But the key is not waiting too long to get in front of the rate environment because conditions could be fleeting.”