Key takeaways:
- Surging oil prices driven by the Iran conflict have reignited inflation concerns, but provided the conflict is short and inflation expectations remain anchored, certain central banks may favor ‘tough talk’ over restrictive policy.
- Asymmetric downside macro risks cause us to favor high quality securitized credit, particularly residential mortgage-backed securities (RMBS) and asset-backed securities (ABS) that offer attractive short-duration carry.
- Investment grade corporate bonds overcame a short-term hurdle as heavy Q1 supply was well absorbed, potentially setting up improved technicals. Across corporates as a whole, while yields and spreads have gapped wider, we are cautious to add risk until greater clarity emerges.
Heightened uncertainty favors selectivity over broad risk-taking
The conflict in the Middle East and its geopolitical and economic repercussions is dominating markets. Near term, the supply disruption to energy and key chemicals could affect headline inflation but the longer-term impact is still debated. For now, longer-term inflation expectations remain anchored, and this offers the prospect of central banks taking a more measured response to any price pressures. From a demand perspective, high oil prices raise costs for business and depress real incomes, potentially dampening growth in the economy. Offsetting this somewhat are targeted support measures across many countries, while in the U.S. tax refunds could support discretionary spending despite rising gasoline prices.
Yields across fixed income asset classes appear attractive relative to the past decade. In contrast, spread levels in many areas remain towards the tighter end of their ranges, even after recent widening has propelled them to more favorable levels.
We prefer the short-duration, high quality carry available in securitized credit over corporates, where spreads remain relatively tight and recent spread widening can largely be explained by sector-specific pressure. Within securitized we see opportunities in residential mortgage-backed securities (RMBS) given improved valuations and stable fundamentals, and asset-backed securities (ABS), given U.S. consumer resilience and attractive income levels in Europe.
Key to market direction will be how the conflict and any ceasefire/resolution unfolds. Against a backdrop of heightened uncertainty and asymmetric risks, we prioritize selective risk taking and security selection over macro calls or broad beta exposure. In our quarterly “Perspectives” document we share our views on the fixed income market and our quarterly asset allocation ranking. We highlight a timely chart to watch, explore relative value opportunities, and provide insight on our latest asset allocation scores by fixed income sub-sector.
IMPORTANT INFORMATION
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 and can experience sudden and sharp price swings. 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.
Securitized 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.
Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.
