Where this fundie sees opportunity, as the macro picture changes yet again

The US Fed last week left the US cash rate within the 5% to 5.25% band - a decision that wrong-footed many market watchers. Even so, more rate rises are almost certainly ahead, as inflation in the US (and nearly everywhere else) remains worryingly high.

But while householders the world over brace for more pain as central banks are tipped to lift rates further over the course of the week, the changing environment since last March has heralded better times for credit markets.

It’s been a long, cold winter but the thaw led by rising inflation and central bank activity means fixed income again – at last – provides attractive income and total return opportunities.

“It has been a long time since fixed income, and in particular high quality fixed income, has offered investors both yield and ballast,” says Adam Grotzinger, Neuberger Berman’s senior fixed income portfolio manager.

But Grotzinger warns the supportive environment is nearing its end, meaning a lift in “idiosyncratic risk and credit stress” for credit investors.

In the following interview, he delves into what this means for investors and how to best mitigate the negative effects on your portfolio. He explains how his team is positioned in fixed-income assets – from both a geographic and asset class perspective – in line with economic movements around the world.

Grotzinger also details his team’s preferred investment area currently, which represents around 40% of its total portfolio.

What’s your snapshot of the current investment landscape, particularly for income investors?

As central banks come to the end of their interest rate hiking cycles, fixed-income markets are offering investors attractive income and total return opportunities.

While return and income potential have become more attractive, it is not without risks. In particular, idiosyncratic risk and credit stress will become more prominent given the backdrop of ongoing restrictive policy rates, slowing growth, and a decline of credit issuance into the real economy.

The combination of these factors favours an active approach to fixed-income portfolio management in the current environment.

In line with renewed investor interest in fixed income, what are some of the most important reminders or lessons needed?

It has been a long time since fixed income, and in particular high-quality fixed income, has offered investors both yield and ballast. Investors should be reminded of the foundational benefits of a fixed-income portfolio. 

Fixed income serves as a diversifying allocation relative to other risk assets in a broader asset allocation framework, seeking to provide stability and ballast to the overall portfolio while often also generating income and total return.

Unlike the last market cycle, however, central banks are less likely to support credit markets and asset prices given the ongoing backdrop of inflation being higher than target.

In this environment, idiosyncratic risk and credit stress will become more prominent, necessitating robust research processes to mitigate capital loss from credit events and favouring an active approach to sector asset allocation.

As of the end of April, the portfolio is around 87% weighted to the US. Does this mean you are bullish on the region and ignoring the talk about an impending recession?

Our view continues to be that we will see sluggish US growth this year. We see US growth at around 0% in real terms and positive in nominal terms.

There are attractive relative value opportunities in the US fixed-income market that benefit from this economic reality. Notably, one of our most significant portfolio changes has been to increase our allocations to US Agency Mortgages (see Are Agency Mortgages a Home Run?). Exposure to this sector today represents ~40% market value of the portfolio. From a valuation perspective, this is one of our favourite asset classes as it offers high quality, 4.5% to 5.0% yields, with attractive convexity characteristics.

Where are you finding opportunities outside the US?

There are select opportunities across emerging markets and developed economies outside the US that provide diversification and return benefits. We have purposely been lighter on ex-U.S. exposure as we believe the fundamental growth backdrop is not as constructive outside the US, and the left tail scenario within emerging markets provides a less attractive risk-return trade-off.

How are you currently positioned across government bonds vs corporate bonds, and how has this changed over the last 6-12 months?

We’re placing a greater emphasis in the portfolio on high-quality and highly liquid assets such as Agency MBS (previously described – see Are Agency Mortgages a Home Run? for rationale) at the expense of corporate credit given our view that idiosyncratic risk and credit stress will rise over the coming 12-18 months.

As it relates to corporate credit: While we still see a rationale for having exposure, we have been using strength in the credit markets (credit spread or margin tightening) to reduce overall market value exposure, recalibrate individual position sizes, and reorient the portfolio to more defensive vs cyclical sectors. Our credit analysts have also been re-underwriting credits to stress test for debt serviceability metrics even in a more severe downside growth scenario.

Lastly, we’re finding attractive opportunities in securitized credit; particularly within higher quality CMBS deals where we believe valuations are cheap relative to fundamentals and even to downside scenarios as they relate to CRE.

Which sectors are you most exposed to within corporate debt and what’s your investment rationale for this positioning?

Given the macro thesis outlined earlier of slow/sluggish growth, restrictive policy rates and reduced credit into the economy, we have been rotating to a more conservative corporate credit posture.

In corporate credit, both investment grade and high yield, the rotation has been out of overly cyclical industries, businesses that skew asset-rich and cash flow light, overly capital-intensive businesses, and businesses that are less versus more diversified. 

 Notably, we have reduced exposure to autos, communications (notably in the HY market), consumer cyclicals, and energy.

In the portfolio, HY and IG corporate sector exposure has been reduced by around 9% and 6%, respectively, in the year so far.

Can you take me through the selection process for credit assets making the Strategic Income fund, and what is the most critical part of your investment process?

We’re a research-driven investment team, that seeks to find opportunities and manage risk by leveraging deep fundamental credit research that informs our views on relative valuation across the global fixed-income markets.

The team’s investment decision-making process has two key elements:

• An asset allocation framework for selecting specific sectors and dynamically allocating risk over time across the opportunity set; with the objective to capture best relative value, enhance returns and provide tail risk protection.
• Bottom-up security selection is performed across the broad opportunity set, with the consistent objective to find the best, high-conviction individual issuer ideas and combine them in a benchmark-agnostic way.

What are you most optimistic about for the next few years?

Given the repricing we experienced over the last 18 months with central banks tightening monetary policy globally, fixed income is a competitive asset class again potentially offering investors attractive, positive real returns.

In addition to more attractive return opportunities, we expect the diversification benefits of fixed income to return as negative correlations to risk assets return following this period of market dislocation.

Finally, we expect the dispersion across asset classes to increase as investors weigh risk across opportunities with the cost of capital being non-zero. This places an emphasis on security selection and active management, two things our firm and team are particularly well positioned for. 

Exploiting mispriced sectors

Investing in the Neuberger Berman Strategic Income Fund provides access to a diversified, multi-sector fixed income strategy that seeks high income and an attractive total return from flexible sector and intra-sector asset allocation across global fixed income markets.

Managed Fund

Neuberger Berman Strategic Income Fund

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