Fixed income to step into the spotlight as US growth slows | Fixed Income

Fixed income is expected to outperform as the US economy slows and interest rates fall, say fund managers who foresee strong demand from Asian institutional investors for short-duration Treasuries, investment-grade and high-yield bonds.

In particular, Asia’s high-yield bond market is back in the spotlight as a portfolio diversifier and source of alpha.

“Our base case for the US economic growth is not a recession. It’s more about slower growth, which, combined with looser monetary policy, could be very supportive for not just fixed income, but potentially also for the broader equity markets in the US,” said Scott Dolan, head of US multi-sector fixed income at UBS Asset Management. Dolan is based in New York.

UBS expects the Federal Reserve to cut rates twice this year by a total of 100 basis points — first in September, then likely in November — aligning with the market consensus and what has already been priced in.

A key metric for Dolan is the three-month moving average of nonfarm payrolls, which has slowed from over 300,000 jobs to under 200,000, suggesting a weakening larbour market.

“We have observed inflection points of economic cycles where we tend to get large revisions in the jobs data,” Dolan told AsianInvestor during his recent trip to Asia.

“We note that more recent initial releases of the nonfarm payrolls are being revised downward and are potentially overstating the health of the labour market.

“The resilience of job growth in the face of policy tightening has been a concern to bond investors.”

WEAK JOB GROWTH

Global stock markets went into a meltdown in early August as US July job growth slowed much more than expected. The market soon consolidated and bounced back, albeit with recession concerns attached.

As inflation is cooling down quickly towards the Fed’s 2% target, Dolan said investors should be less concerned about inflation and tight labour markets and more concerned with the slowing economic growth.

“This will likely be a catalyst that leads to the Fed’s shift in monetary policy,” he said.

With rates expected to fall further in 2025, he noted that the “compelling” case for fixed income is the prospect of earning income from coupons and price gains when rates drop.

“I would envision more support from Asia for the US bond market going forward on the institutional side, given those interest rate differentials, and versus their local bond markets,” he said.

Hypothetically, with rates down 100 basis points, he expects a 10-11% annualised return for a 6% yielding, five-year duration bond, including a 5% capital appreciation. Even if rates rose by 100bps, the 6% income would leave returns positive.

In the US, Dolan’s team has exposure to high-yield and investment-grade bonds, where they see a supportive supply environment.

The team is neutral on investment grade, with a preference for non-US corporates. In the high-yield space, they prefer euro high yield and short-duration names, looking to add exposure in select industries where conviction is higher.

The team is also becoming more constructive on China high-yield, given valuations. In emerging markets, it likes investment-grade corporates.

To limit volatility from Fed policy shifts, it prefers hard currency over local currency positions. With the broadly supportive global monetary backdrop ex-Japan, Dolan expected modest US dollar weakness to boost hard currency emerging market bonds, such as Indonesia, Mexico, and Brazil.

“We’re likely to see some appreciation and yields come down in their bond markets. So that’s the area [where] I’m spending a lot of time today, in the risk markets in fixed income as potential alpha drivers for our portfolios,” he said.

GO SHORT DURATION

As the market anticipates Fed cuts, some managers aim to add short-duration fixed income positions.

Elaine Wu, BlackRock’s head of APAC investment and portfolio solutions, cited the one- to three-year and three- to seven-year US Treasury indexes to gain this exposure.

“We think the tail end is not as attractive,” Wu said in a press conference recently.

She flagged Asia’s high yield as attractive versus its US counterparts, advocating an active approach focused on strong fundamentals and low default risks.

BlackRock also likes Indian government bonds as a diversifier, given their low correlation with global high-yield and emerging market debt.

In the high-rate era, trillions of dollars remain in cash and money market funds, noted Alastair Sewell, liquidity investment strategist at Aviva Investors.

He expected investors to first move into high-quality short-duration products and then begin adding duration, without taking too much risk.

“High yield is a short-duration asset class as well, but clearly it takes more risk. Some investors will certainly go there.

“But I think it’ll be that first step out of conservative, low-risk allocations, back into the risk market, which is probably going to be that short-duration space. And I think that space is going to be super interesting,” Sewell told AsianInvestor.