PGIM Fixed Income has a positive one-year outlook for US and European investment grade corporate bonds with maturities of up to 10 years and for shorter-dated US high yield credit.
Many issues in the sector provide alpha opportunities through relative value analysis, credit beta exposure, and income and risk hedges – and despite attractive nominal deposit rates, have an advantage over cash, Gabriel Doz, fixed income portfolio strategist at PGIM told FSA.
“From current yield levels, long term, expected returns for fixed income are compelling across a range of potential economic scenarios,” he said.
Notably, investment grade European and US indices yields are between 4% and 6%, and sub-investment grade yields are approaching 9%. PGIM’s fixed income strategy is overweight short-dated BBB issues as well as single-A financials, and generally tilts towards credit rather than government bonds.
A high risk-free rate (the yield of US Treasury bills) plus option-adjusted spreads (OAS) are compelling reasons to continue to buy corporate bonds, despite recent spread compression, according to Doz. The total yield for investment grade of 5.83% and 8.66% (463 basis points [bps] risk-free rate plus 403 bps OAS for US high yield) are still attractive, he said.
“After a decade of ultra-low interest rates, yields have reverted back to historically ‘normal’ ranges,” Doz (pictured) said.
In particular, “there has also been a significant increase in high yield (single-B) dispersion, which offers opportunities for potential value creation in selected issuers and sectors,” he added.
Within emerging markets, PGIM is positive about sovereign and corporate high yield hard currency bonds and also selectively local currency debt, although Doz is wary of a strong dollar eroding returns.
Among possible US economic scenarios for the next 12 months, the firm assigns the biggest probability (35%) to “weakflation”, a downturn in inflation but also below-trend growth, which will allow the US Federal Reserve (Fed) to fine-tune policy rates with two-to-three rate cuts next year.
There is a risk of a recession, magnified by the effect of high public debt on government borrowing costs, but the worst-case scenario is strong growth combined with stubborn inflation which might force the Fed to hike interest rates, said Doz.
PGIM Fixed Income has $744bn of AUM (as of 30 September 2023) and over 1,000 clients, according to the US-headquartered global asset manager’s website.
“The unusual confluence of significant short-term and long-term cross winds are likely to continue to generate confusion, but also opportunities to add value through active management,” Doz said.
“Therefore, risk assets should perform reasonably well, though still elevated inflation will likely keep yields quite high.”