Key takeaways:
- Tight credit spreads do not necessarily signal an imminent reversal, but they do require investors to focus on relative value and careful security selection.
- AI is creating both opportunities and risks in fixed income, with heavy investment potentially pressuring investment grade spreads while opening value in high yield and securitized assets.
- In an environment of sticky inflation and shifting correlations, a more selective and active approach to fixed income, favoring shorter-duration and securitized exposures, may help improve risk-adjusted returns.
IMPORTANT INFORMATION
Actively-managed portfolios may fail to produce the intended results. No investment strategy can ensure a profit or eliminate the risk of loss.
Artificial intelligence (“AI”) focused companies, including those that develop or utilize AI technologies, may face rapid product obsolescence, intense competition, and increased regulatory scrutiny. These companies often rely heavily on intellectual property, invest significantly in research and development, and depend on maintaining and growing consumer demand. Their securities may be more volatile than those of companies offering more established technologies and may be affected by risks tied to the use of AI in business operations, including legal liability or reputational harm.
Bank loans often involve borrowers with low credit ratings whose financial conditions are troubled or uncertain, including companies that are highly leveraged or in bankruptcy proceedings.
Collateralized Loan Obligations (CLOs) are debt securities issued in different tranches, with varying degrees of risk, and backed by an underlying portfolio consisting primarily of below investment grade corporate loans. The return of principal is not guaranteed, and prices may decline if payments are not made timely or credit strength weakens. CLOs are subject to liquidity risk, interest rate risk, credit risk, call risk and the risk of default of the underlying assets.
Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.
Fixed income securities are subject to interest rate, inflation, credit and default risk. As interest rates rise, bond prices usually fall, and vice versa. High-yield bonds, or “junk” bonds, involve a greater risk of default and price volatility. Foreign securities, including sovereign debt, are subject to currency fluctuations, political and economic uncertainty and increased volatility and lower liquidity, all of which are magnified in emerging markets.
Technology industries can be significantly affected by obsolescence of existing technology, short product cycles, falling prices and profits, competition from new market entrants, and general economic conditions. A concentrated investment in a single industry could be more volatile than the performance of less concentrated investments and the market as a whole.
Securitised products, such as mortgage- and asset-backed securities, are more sensitive to interest rate changes, have extension and prepayment risk, and are subject to more credit, valuation and liquidity risk than other fixed-income securities.
Volatility measures risk using the dispersion of returns for a given investment.
Alpha: Excess return generated by an investment relative to a benchmark index, typically attributed to active management or investment skill.
Carry: The return earned from holding an asset over time, primarily derived from income such as coupon payments rather than price appreciation.
Convex (convexity): A measure of the curvature in the relationship between bond prices and interest rates, indicating how duration changes as yields change.
Core PCE: Core Personal Consumption Expenditures index, a measure of inflation that excludes volatile food and energy prices and is closely monitored by central banks.
Correlation: A statistical measure that describes the degree to which two variables, such as asset prices or returns, move in relation to one another.
Credit spread: The difference in yield between a corporate bond and a government bond of similar maturity, reflecting the additional risk of the issuer.
Default risk: The risk that a borrower will be unable to meet interest or principal repayments on a debt obligation.
Dispersion: The degree of variation in returns among securities within a market or asset class, often creating opportunities for selective investment.
Duration: A measure of a bond’s sensitivity to changes in interest rates, indicating how much its price is expected to change when rates move.
Extension risk: The risk that the maturity of a securitized asset will lengthen due to slower-than-expected repayment, often occurring when interest rates rise.
Fannie Mae and Freddie Mac: US government-sponsored enterprises that support the mortgage market by purchasing and guaranteeing mortgages, thereby providing liquidity to mortgage lenders.
High-yield bonds: Bonds issued by companies with lower credit ratings than investment grade, offering higher yields to compensate for increased credit risk.
Investment grade: A credit rating indicating that a bond is assessed as having a relatively low risk of default by rating agencies.
Liquidity risk: The risk that an investment cannot be bought or sold quickly enough in the market to prevent or minimize a loss.
Prepayment risk: The risk that a borrower will repay a loan or security earlier than expected, potentially reducing the investor’s anticipated income.
Relative value: An investment approach that seeks to exploit pricing differences between related securities or markets.
Resi credit: Residential mortgage-backed or housing-related credit instruments backed by pools of residential loans.
Risk-adjusted return: A measure of an investment’s return relative to the level of risk taken to achieve it.
Securitized products: Financial instruments created by pooling assets such as mortgages or loans and issuing securities backed by these cash flows.
Security selection: The process of choosing individual securities within an asset class based on analysis of their characteristics and valuation.
Spread per unit of volatility: A measure of return that evaluates the excess yield earned relative to the level of price variability or risk.
Volatility: A statistical measure of the degree of variation in the price of a financial instrument over time, often used as an indicator of risk.
Tom Ross (TR): Hello and welcome. I’m Tom Ross, Head of High Yield and portfolio manager on the Multi-Sector Credit Team. And today I’m joined by John Lloyd, our Global Head of Multi-Sector Credit. We’ve recently been meeting with lots of clients. And so we’re going to share with you some of the key questions that those clients have been asking.
And then we’re also going to touch on topics such as AI, rates, and also where are the opportunities and how to invest, we believe, in the future of fixed income.
Okay, so John, first question for you in meeting clients, one of the key questions is spreads are really tight, what should we do?
John Lloyd (JL): Yeah, I think an overarching theme is you want to maximize spread per unit of volatility in these type of environments and not stretch for yield. There’s lots of relative value opportunities across the sectors. There’s also a lot of dispersion within the sectors and themes you can invest in. We’ll get to AI, but AI is a huge theme we’ve been investing in. And I think there’s a lot of reasons why spreads are tight.
TR: Tight spreads don’t necessarily mean they’re going to widen, but we’ve got better credit quality within most of the public credit universe. We’ve got lower duration within areas like high yield as well. And generally the fundamentals of corporates are looking pretty good. So I think spreads are tight for a reason as opposed to saying spreads are tight, therefore that means they’re going wider.
JL: Yeah. And we’ve had lots of time periods early 2000s, 2010 where we had long stretches of tight spreads that you still want to harvest yield and you just want to do it in a responsible way. So I think those are examples where you can you can still get comfort in kind of a tight spread environment.
And the fundamentals are really strong. You know GDP growth in the US is above trend. Europe’s been accelerating I know we’ve had some conflicts this year that have, you know, put a hiccup in some of the markets. But that creates opportunities too.
TR: Okay. Let’s move on to AI. So opportunities and risks. You go first.
JL: I think we looked at it as a risk in the investment market. The hyperscalers are spending, you know, US$800 billion this year. Trillion dollars plus next year. That supply is going to come in mostly through the investment grade market. Investment grade spreads are already starting near all-time tights. And I think that supply technical could widen out spreads in that market. So that’s an example of a risk in the fixed income market.
In high yield and securitized you can get some pretty good spreads investing in AI. We’ve seen in high yield, we’ve seen examples of investing in kind of second derivatives of AI as well. Utility companies because there’s a power backlog, tech hardware, memory players. And we’ve seen companies in those spaces get upgraded and spreads tighten.
TR: Yeah. And we’ve also had the data centre deals as well, which were a really great opportunity when it first came. Now it’s a little bit more selective and we’ve got lots more issuance to come there, but I think that will also drive some opportunities. In fact, in Europe recently we’ve had one of the first deals announced for a European data centre deal as well.
Um, okay. So let’s talk about rates a little bit. How are we thinking about rates – AI inflationary or disinflationary?
JL: I’m in the camp that AI is going to be near-term, over the next 18, 24, maybe even 36 months, inflationary. We’ve seen the employment numbers in the US really hold up. One of the stats I like to bring to the forefront is software engineering hiring is up year over year. So if you’re going to see job displacement, you probably see it in that sector first. And we’re just really not seeing that.
And then you get news like Apple raising prices on iPhones. You’re seeing it in the hardware. You’re seeing it in utility prices. So, and we’re already starting at a relatively high rate in the core PCE, so I think inflation is going to be sticky. And I think it’s one of the risks to manage in the fixed income markets.
I think also correlations – you want to touch upon the correlations?
TR: Yeah. So obviously that has sort of switched from being negative to potentially going positive again in terms of equity and rates correlation, which is actually what we saw prior to the year 2000. So I think that just means we just need to consider those correlations. Ultimately, part of many of the strategies we use duration as a volatility dampener.
So it’s really considering those correlations. But yeah ultimately we believe now the best use of fixed income is more that short-end carry as opposed to that long-end sort of protection type of hedge.
JL: Agreed.
TR: Okay. And then to finish off, in terms of where do we think the best opportunities are and how do we invest, or how do we think clients should think about investing in fixed income going forward?
JL: Another great topic. I think there’s an example going back to what I started with, of maximizing that spread per unit of volatility. I think in the mortgage market and the resi credit space. That’s a great way to do it. Why is there going to be less volatility? Well you have Fannie and Freddie purchasing over, you know, US$200 billion in that market.
That’s probably going to reduce the vol throughout the year in those sectors. So those are areas we like. And generally we like securitized. It tends to be shorter duration front end. And those spreads versus their own history tend to be cheaper than the corporate credit side. So it’s not that we don’t like corporate credit. Just securitized offers a little bit better risk adjusted yields and returns.
TR: I’ll add to that as well. In a sort of benign environment where spreads stay tight, then it’s really that function to focus on security selection within all of the different asset classes within fixed income. But then if we do get any volatility, that’s when being overweight in more defensive but high yielding securitized right now might then lead to opportunities like we’ve seen in the past to then switch into those higher convex, more upside fixed income asset classes like investment grade, emerging markets, and higher yield.
Great. Well, thanks very much for listening. And of course, if you have any further questions, please reach out to your sales representative.
These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy or market sector, and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees, may have a position in the securities mentioned.
Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.
The information in this article does not qualify as an investment recommendation.
There is no guarantee that past trends will continue, or forecasts will be realised.
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- The risks of investing in collateralised loan obligations (CLOs), include both the economic risks of the underlying loans combined with the risks associated with the CLO structure governing the priority of payments. The degree of such risk will generally correspond to the specific tranche in which the Fund is invested. Ratings do not constitute a guarantee, may be downgraded, and in stressed market environments it is possible that even AAA-rated CLO tranches could experience realised or mark to market losses due to actual underlying loan default losses, erosion of the subordinated/equity tranches that support the AAA-rated notes due to such losses, market anticipation of future defaults, as well as negative market sentiment with respect to CLO securities as an asset class. The Fund’s portfolio management may not be able to accurately predict how specific CLOs or the portfolio of underlying loans for such CLOs will react to changes or stresses in the market. The most common risks associated with investing in CLOs are liquidity risk, interest rate risk, credit risk, and prepayment, extension or call risk, amongst others.
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- Lower liquidity means there are insufficient buyers or sellers to allow the Fund to sell or buy investments readily.
Specific risks
- An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall.
- When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise (or are expected to rise). This risk is typically greater the longer the maturity of a bond investment.
- The Fund invests in high yield (non-investment grade) bonds and while these generally offer higher rates of interest than investment grade bonds, they are more speculative and more sensitive to adverse changes in market conditions.
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- The Fund may use derivatives to help achieve its investment objective. This can result in leverage (higher levels of debt), which can magnify an investment outcome. Gains or losses to the Fund may therefore be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
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- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
Specific risks
- An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall.
- When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise (or are expected to rise). This risk is typically greater the longer the maturity of a bond investment.
- The Fund invests in high yield (non-investment grade) bonds and while these generally offer higher rates of interest than investment grade bonds, they are more speculative and more sensitive to adverse changes in market conditions.
- Some bonds (callable bonds) allow their issuers the right to repay capital early or to extend the maturity. Issuers may exercise these rights when favourable to them and as a result the value of the Fund may be impacted.
- Emerging markets expose the Fund to higher volatility and greater risk of loss than developed markets; they are susceptible to adverse political and economic events, and may be less well regulated with less robust custody and settlement procedures.
- The Fund may use derivatives to help achieve its investment objective. This can result in leverage (higher levels of debt), which can magnify an investment outcome. Gains or losses to the Fund may therefore be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- The Fund may incur a higher level of transaction costs as a result of investing in less actively traded or less developed markets compared to a fund that invests in more active/developed markets.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- CoCos can fall sharply in value if the financial strength of an issuer weakens and a predetermined trigger event causes the bonds to be converted into shares/units of the issuer or to be partly or wholly written off.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.