Fixed-income opportunities are often either high yield or high quality, but not often both. The current environment is different, however, and Western Asset Management Company is favoring high-quality fixed income credit as a defensive strategy against interest rate volatility and the uncertain economic outlook.
Such opportunities may be found in sectors of the market that bore the brunt of bearish sentiment, such as agency mortgage-backed securities (MBS), Western Asset investment executives said in its fifth PM Exchange webcast, addressing fixed-income concerns and opportunities for the next six to 12 months.
"Investors right now have a unique opportunity to combine both quality and higher yields, which is something we have not seen in a long time," Michael Buchanan, co-chief investment officer said.
Western Asset is far from alone in using that tactic. Longer-duration, fixed-income (for now) investors have sent funds flowing into the market, outstripping supply. The real winners this year have been U.S. insurance companies and Asia-based buyers, who had been investing in the last few years at 2%-3% and are now able to invest high-quality portfolios at 5.5%-6%, said Ryan Brist, Western Asset's head of global investment-grade credit.
Investors right now have a unique opportunity to combine both quality and higher yields, which is something we have not seen in a long time
Western Asset doesn't believe that the current rush is a systemic change, however, pointing out that the uncertain outlook for the U.S. economy and interest rate movements are responsible for the deluge of investment-grade credit. Also, many issuers of investment-grade debt refinanced their balance sheets in 2020 and 2021 with long-duration, low-rate loans, so they aren't forced borrowers in today's market, said Brist.
CMBS offers opportunities
In the commercial real estate lending and commercial mortgage-backed securities (CMBS) markets, the value lies in better-performing sectors including industrial warehouses and distribution centers that serve e-commerce companies such as Amazon.
"We've seen tremendous growth in demand for distribution centers," said Simon Miller, a Western Asset portfolio manager.
The data centers sector is also a growing niche, with big demand from artificial intelligence (AI) companies and providers of data storage for online content.
The office market is fundamentally challenged by what Miller calls a perfect storm of lower occupancy rates and mortgage rates that have nearly doubles since many maturing office loans were originated. Finding new financing is further challenged because coupon rates are at least two times higher than the existing financing that borrowers have, he said.
Investment opportunities exist among high-quality office space in desirable locations, however. Some large employers are announcing return to office policies, and capital is going into markets such as San Francisco that were impacted by the flight of workers.
"The best returns are for Tier 1 properties that are going to outperform," said Miller. "So, we aren't avoiding the office market altogether, but we're cautious."
Prospects in the retail sector are similar. The highest quality retail centers are strong, as consumers continue to flock to class-A trophy, super-regional malls.
"COVID resulted in a reckoning for lower-quality retail centers, which had been challenged for many years," said Miller.
According to Fitch Ratings, the U.S. CMBS delinquency rate increased eight basis points to 2% in August from 1.92% in July. Contributing to the fourth consecutive month's increase were new mixed-use and regional mall delinquencies, alongside continued office delinquencies, Fitch said.
Currently, the hospitality and lodging sector is strong and seeing record revenues, as is self-storage. That positive trend might not necessarily hold, Miller said.
"If there is a downturn in economic activity and consumers are under pressure regarding travel, this would affect the hospitality sector."
In the residential real estate market, Federal Reserve monetary policies have created conditions for a soft landing for an economy that was expected to go into a recession, according to Greg Handler, head of Western Asset's mortgage and consumer credit team.
"This year has seen a good rebound with house prices returning to the 3%-5% growth of pre-COVID days," he said. "Yields and spreads are the highest we have seen in the last 10 years. So, we do like mortgage credit."
Agencies under pressure
The agency mortgage market has been under a lot of pressure and is underpriced, Handler believes. Interest-rate increases and the Fed's pullback from buying mortgages in the second half of 2022 made last year one of the worst years for performance. This year, agency mortgages have had a lot of volatility compared with Treasurys and mortgage-lending activity has been low.
"We think agency mortgages are cheap versus comparable Treasurys," Handler said. "Agency mortgages are yielding 5.2%, which is 75 basis points higher than equivalent Treasurys. We haven't seen these spread levels since 2009 and it's largely due to banks being hesitant to buy."
Interest rate volatility has been a big headwind, Handler said, but, as the market gets more comfortable about the Fed's end game and the timing and pace of rate cuts, the agency mortgage market should outperform.
"We think banks are only out of the agency market temporarily and, as they get better clarity on rate volatility, Ginnie Mae mortgages' yield levels will be very attractive to them," he said.
Western Asset particularly favors the slightly higher yield of Ginnie Mae mortgages over Fannie Mae or Freddie Mac, and is overweight on the (Ginnie Mae) asset class, Handler said.
