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Leaning into income in fixed income
Market take
Weekly video_20240701
Devan Nathwani
Opening frame: What’s driving markets? Market take
Camera frame
Today’s high-for-longer rate environment makes income-earning assets more attractive than at any time in the past decade.
Title slide: Leaning into income in fixed income
The total income on offer across the credit space provides long-term investors relatively safe yield.
We prefer pockets of credit where the total yield better compensates investors for credit risk.
1: Higher rates, higher yields
In the wake of the historic global interest rate hiking cycle, long-term investors no longer need to take on excess risk to generate solid income.
Higher yields mean the income is back in fixed income.
2: Staying selective
While the total income on offer is attractive for fixed income investors, we stay selective in credit. Spreads have tightened, largely as a function of limited new supply and resilient corporate balance sheets.
We get granular, preferring high yield over investment grade credit where the total income is higher. Regionally, we prefer European over U.S. credit where spreads aren’t as tight.
3: Our differentiated credit views
We like private credit over public credit on a strategic horizon of five years and longer.
Yet private markets are complex, with high risk and volatility, and aren’t suitable for all investors.
Outro: Here’s our Market take
We like pockets of credit where investors are more compensated for risk. Yet in a whole-portfolio context, we prefer taking risk in equities.
Closing frame: Read details:
www.blackrock.com/weekly-commentary
Finding yield
Total income has returned to credit thanks to higher-for-longer interest rates. We prefer pockets of credit where investors are better compensated for risk.
Market backdrop
U.S. stocks ticked up to fresh all-time highs last week. U.S. PCE for May was flat month over month, the latest measure showing decelerating price growth.
Week ahead
We’re monitoring this week's U.S. payrolls data to see if rapid job gains will continue and if wage pressures remain elevated.
The higher-for-longer rate environment has restored income in a range of different bonds. Total yields on offer in credit – in investment grade, mortgage-backed securities and high yield – provides long-term investors relatively attractive yield returns to risk, especially in shorter-term bonds. We favor areas where investors are more compensated for risk, preferring Europe over the U.S. and private credit over public. From a whole portfolio perspective, we prefer taking risk in equities.
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Paying less interest
Non-financial corporate net interest payments, 1985-2024
Past performance is no guarantee of future results. Index returns do not account for fees. It is not possible to invest directly in an index. Source: BlackRock Investment Institute, U.S. Bureau of Economic Analysis (BEA), U.S. Department of Commerce with data from LSEG Datastream, July 2024. Notes: The chart shows the net interest paid by non-financial companies and the rest of the world for the U.S.’ financial resources. Read more in the BEA’s handbook.
Today is a different world for fixed income investing compared with pre-pandemic. After a historic string of central bank rate hikes, 86% of global fixed income assets are now yielding 4% or more, versus less than 20% in the decade leading up to the pandemic, LSEG Datastream data show. This means long-term investors no longer need to take on extra risk to generate solid income. And U.S. companies are proving resilient to higher rates. U.S. investment grade companies have less than 10% of outstanding debt coming due annually through 2030, Bloomberg data show. We don’t see a maturity wall ahead that could raise questions about companies refinancing at higher rates. Many companies took advantage of low rates early in the pandemic, converting short-term debt to long-term. As a result, U.S. corporate net interest payments have plunged even after sharp rate hikes. See the chart.
While the total income on offer is attractive for fixed income investors, we stay selective in credit. Spreads have tightened, largely a function of strong demand relative to supply and resilient corporate balance sheets. Spreads for U.S. investment grade companies are near their tightest levels in two decades – keeping us underweight. Within credit, we prefer the income from short- and intermediate-term bonds and pockets that compensate investors for risk-taking. We are neutral high yield credit globally on both a tactical and strategic horizon. The income cushion makes high yield more attractive on a total return basis relative to investment grade, in our view. We get granular by region, preferring European longer-term credit over the U.S. – spreads in Europe are not as tight relative to the U.S. or to their own history. We are keeping an eye on the French parliamentary election heading into the second-round vote on July 7. France makes up almost 20% of the European corporate bond universe, Bloomberg data show.
Sticking with equities tactically
In a whole portfolio context, we prefer taking risk in equities – where expected returns are more attractive – over credit on a tactical horizon of six to 12 months. We stay overweight stocks and the AI theme.
On strategic horizons of five years and longer, we like private credit over public – even as U.S. direct lending default rates have risen, according to Lincoln International data. Defaults could be even higher if not for lender flexibility on companies breaching credit agreements. This factors into our conservative default assumptions for private credit – twice those of public high yield. Yet even after accounting for those potential losses, we remain positive. Defaults are still relatively limited. Private credit should also play a key role in the future of finance: We see rising appetite for non-bank lending driving steady demand for private credit. Private markets are complex, with high risk and volatility, and aren’t suitable for all investors.
Bottom line
The fastest rate hikes in decades have put total income back into fixed income. We like pockets of credit where investors are more compensated for risk – like Europe over U.S., high yield over investment grade and private over public. Yet in a whole portfolio context, we prefer taking risk in equities.
Market backdrop
U.S. stocks rose to fresh all-time highs last week. U.S. PCE for May was flat monthly as expected, the latest inflation measure showing decelerating price growth. We watch for whether inflation ultimately cools enough to settle near the Fed’s 2% goal. French assets came under pressure heading into the first round of the snap election. Spreads on French 10-year government bonds over German bunds pushed back to their widest level since the euro area crisis. French stocks hit five-month lows.
We’re keeping an eye on the U.S. payroll report out this week to gauge if recent rapid job gains will continue, boosted by bumper immigration flows. We're also watching whether pay growth remains elevated: It's currently running too hot for inflation to settle near the Fed’s 2% target, in our view.
Week ahead
Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from LSEG Datastream as of June 27, 2024. Notes: The two ends of the bars show the lowest and highest returns at any point year to date, and the dots represent current year-to-date returns. Emerging market (EM), high yield and global corporate investment grade (IG) returns are denominated in U.S. dollars, and the rest in local currencies. Indexes or prices used are: spot Brent crude, ICE U.S. Dollar Index (DXY), spot gold, MSCI Emerging Markets Index, MSCI Europe Index, LSEG Datastream 10-year benchmark government bond index (U.S., Germany and Italy), Bank of America Merrill Lynch Global High Yield Index, J.P. Morgan EMBI Index, Bank of America Merrill Lynch Global Broad Corporate Index and MSCI USA Index.
July 2
Euro area flash inflation and unemployment data
July 3
U.S. trade data; Caixin services PMI
July 5
U.S. payrolls data
Read our past weekly market commentaries here.
Big calls
Our highest conviction views on tactical (6-12 month) and strategic (long-term) horizons, July 2024
| Reasons | ||
|---|---|---|
| Tactical | ||
| U.S. equities | Our macro view has us neutral at the benchmark level. But the AI theme and its potential to generate alpha – or above-benchmark returns – push us to be overweight overall. | |
| Income in fixed income | The income cushion bonds provide has increased across the board in a higher rate environment. We like short-term bonds and are now neutral long-term U.S. Treasuries as we see two-way risks ahead. | |
| Geographic granularity | We favor getting granular by geography and like Japan stocks in DM. Within EM, we like India and Mexico as beneficiaries of mega forces even as relative valuations appear rich. | |
| Strategic | ||
| Private credit | We think private credit is going to earn lending share as banks retreat – and at attractive returns relative to public credit risk. | |
| Fixed income granularity | We prefer inflation-linked bonds as we see inflation closer to 3% on a strategic horizon. We also like short-term government bonds, and the UK stands out for long-term bonds. | |
| Equity granularity | We favor emerging over developed markets yet get selective in both. EMs at the cross current of mega forces – like Mexico, India and Saudi Arabia – offer opportunities. In DM, we like Japan as the return of inflation and corporate reforms brighten our outlook. | |
Note: Views are from a U.S. dollar perspective, July 2024. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any particular funds, strategy or security.
Tactical granular views
Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, July 2024
Our approach is to first determine asset allocations based on our macro outlook – and what’s in the price. The table below reflects this. It leaves aside the opportunity for alpha, or the potential to generate above-benchmark returns. The new regime is not conducive to static exposures to broad asset classes, in our view, but it is creating more space for alpha. For example, the alpha opportunity in highly efficient DM equities markets historically has been low. That’s no longer the case, we think, thanks to greater volatility, macro uncertainty and dispersion of returns. The new regime puts a premium on insights and skill, in our view.
| Asset | Tactical view | Commentary | ||||
|---|---|---|---|---|---|---|
| Equities | ||||||
| United States | Benchmark |  |
We are neutral in our largest portfolio allocation. Falling inflation and coming Fed rate cuts can underpin the rally’s momentum. We are ready to pivot once the market narrative shifts. | |||
| Overall |  |
We are overweight overall when incorporating our U.S.-centric positive view on artificial intelligence (AI). We think AI beneficiaries can still gain while earnings growth looks robust. | ||||
| Europe |  |
We are underweight. While valuations look fair to us, we think the near-term growth and earnings outlook remain less attractive than in the U.S. and Japan – our preferred markets. | ||||
| U.K. | |
We are neutral. We find attractive valuations better reflect the weak growth outlook and the Bank of England’s sharp rate hikes to fight sticky inflation. | ||||
| Japan |  |
We are overweight. Mild inflation and shareholder-friendly reforms are positives. We see the BOJ policy shift as a normalization, not a shift to tightening. | ||||
| Emerging markets | |
We are neutral. We see growth on a weaker trajectory and see only limited policy stimulus from China. We prefer EM debt over equity. | ||||
| China | |
We are neutral. Modest policy stimulus may help stabilize activity, and valuations have come down. Structural challenges such as an aging population and geopolitical risks persist. | ||||
| Fixed income | ||||||
| Short U.S. Treasuries | |
We are overweight. We prefer short-term government bonds for income as interest rates stay higher for longer. | ||||
| Long U.S. Treasuries | |
We are neutral. The yield surge driven by expected policy rates has likely peaked. We now see about equal odds that long-term yields swing in either direction. | ||||
| U.S. inflation-linked bonds | |
We are neutral. We see higher medium-term inflation, but cooling inflation and growth may matter more near term. | ||||
| Euro area inflation-linked bonds |  |
We are neutral. Market expectations for persistent inflation in the euro area have come down. | ||||
| Euro area government bonds | |
We are neutral. Market pricing reflects policy rates in line with our expectations and 10-year yields are off their highs. Widening peripheral bond spreads remain a risk. | ||||
| UK Gilts | |
We are neutral. Gilt yields have compressed relative to U.S. Treasuries. Markets are pricing in Bank of England policy rates closer to our expectations. | ||||
| Japan government bonds |  |
We are underweight. We find more attractive returns in equities. We see some of the least attractive returns in Japanese government bonds, so we use them as a funding source. | ||||
| China government bonds | |
We are neutral. Bonds are supported by looser policy. Yet we find yields more attractive in short-term DM paper. | ||||
| U.S. agency MBS | |
We are neutral. We see agency MBS as a high-quality exposure in a diversified bond allocation and prefer it to IG. | ||||
| Global investment grade credit | |
We are underweight. Tight spreads don’t compensate for the expected hit to corporate balance sheets from rate hikes, in our view. We prefer Europe over the U.S. | ||||
| Global high yield | |
We are neutral. Spreads are tight, but we like its high total yield and potential near-term rallies. We prefer Europe. | ||||
| Asia credit | |
We are neutral. We don’t find valuations compelling enough to turn more positive. | ||||
| Emerging market - hard currency | |
We are overweight. We prefer EM hard currency debt due to its relative value and quality. It is also cushioned from weakening local currencies as EM central banks cut policy rates. | ||||
| Emerging market - local currency | |
We are neutral. Yields have fallen closer to U.S. Treasury yields. Central bank rate cuts could hurt EM currencies, dragging on potential returns. | ||||
Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Note: Views are from a U.S. dollar perspective, July 2024. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast or guarantee of future results. This information should not be relied upon as investment advice regarding any particular fund, strategy or security.
Euro-denominated tactical granular views
Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, July 2024
| Asset | Tactical view | Commentary | ||
|---|---|---|---|---|
| Equities | ||||
| Europe ex UK | |
We are underweight. While valuations look fair to us, we think the near-term growth and earnings outlook remain less attractive than in the U.S. and Japan – our preferred markets. | ||
| Germany | |
We are neutral. Valuations remain moderately supportive relative to peers. The earnings outlook looks set to brighten as global manufacturing activity bottoms out and financing conditions start to ease. Longer term, we think the low-carbon transition may bring opportunities. | ||
| France | |
We are underweight. Relatively richer valuations offset the positive impact from past productivity enhancing reforms and favorable energy mix. | ||
| Italy | |
We are underweight. Valuations and earnings dynamics are supportive. Yet recent growth outperformance seems largely due to significant fiscal stimulus in 2022-2023 that cannot be sustained over the next few years, we think. | ||
| Spain | |
We are neutral. Valuations and earnings momentum are supportive relative to peers. The utilities sector looks set to benefit from an improving economic backdrop and advances in AI. Political uncertainty remains a potential risk. | ||
| Netherlands | |
We are underweight. The Dutch stock markets' tilt to technology and semiconductors, a key beneficiary of higher demand for AI, is offset by relatively less favorable valuations than European peers. | ||
| Switzerland | |
We are underweight in line with our broad European market positioning. Valuations remain high versus peers. The index’s defensive tilt will likely be less supported as long as global risk appetite holds up, we think. | ||
| UK | |
We are neutral. We find that attractive valuations better reflect the weak growth outlook and the Bank of England’s sharp rate hikes to deal with sticky inflation. | ||
| Fixed income | ||||
| Euro area government bonds | |
We are neutral. Market pricing reflects policy rates broadly in line with our expectations and 10-year yields are off their highs. | ||
| German bunds | |
We are neutral. Market pricing reflects policy rates broadly in line with our expectations and 10-year yields are off their highs. | ||
| French OATs | |
We are neutral. Valuations look less compelling following pronounced narrowing of French spreads to German bonds. Elevated French public debt and a slower pace of structural reforms remain challenges. | ||
| Italian BTPs | |
We are neutral. The spread over German bunds looks tight given Italy’s recently higher-than-expected deficit-to-GDP-ratio and a trajectory for the debt ratio in the next few years which is stable at best. Other domestic factors remain supportive, with growth holding up well relative to the rest of the euro area. Italian households are also showing a significant willingness to increase their direct holding of BTPs amid high nominal rates and yields. | ||
| UK gilts | |
We are neutral. Gilt yields have compressed relative to U.S. Treasuries. Markets are pricing in Bank of England policy rates closer to our expectations. | ||
| Swiss government bonds | |
We are neutral. The Swiss National Bank has started to cut policy rates given reduced inflationary pressure and the appreciation of the Swiss franc. | ||
| European inflation-linked bonds | |
We are neutral. Market expectations for persistent inflation in the euro area have come down. | ||
| European investment grade credit | |
We are neutral. We maintain our preference for European investment grade over the U.S. given more attractive valuations amid decent income. | ||
| European high yield | |
We are overweight. We find the income potential attractive. We still prefer European high yield given its more appealing valuations, higher quality and lower duration than in the U.S. Spreads compensate for risks of a potential pick-up in defaults, in our view. | ||
Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Note: Views are from a euro perspective, July 2024. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast or guarantee of future results. This information should not be relied upon as investment advice regarding any particular fund, strategy or security.
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Authors
Wei Li
Global Chief Investment Strategist — BlackRock Investment Institute
Beata Harasim
Senior Investment Strategist — BlackRock Investment Institute
Tom Walsh
Head of U.S. Credit, Fundamental Fixed Income – BlackRock
Devan Nathwani
Portfolio Strategist – BlackRock Investment Institute
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