A Renaissance in U.S. Core Fixed Income: The “Five Percent” Paradox to Start the Year

Despite uncertainties regarding monetary policy and a potential recession, assessing valuations across the bond universe at the start of the year has yielded some interesting fundamentally-driven ideas for 2023, despite the recent bouts of volatility.

Executive summary

— The fixed-income market has shown signs of rebounding from the poor performance of 2022, entering the new year with fundamentals on a strong footing despite swings in volatility.
— Among investment-grade corporate credits, leverage levels have risen slightly, but in a way that has enhanced issuers’ financial flexibility. Long-term trends also bode well for the asset class.
— Within Structured Finance, the market is being supported by consumer fundamentals that remain resilient, supported by a still-healthy job market, although we are seeing subprime borrowers come under pressure due to inflation.
— DWS believes a long-duration opportunity is available in Rate Reduction bonds. While in Commercial Real Estate, certain single properties may be an attractive short-duration investment. Esoteric Asset-Backed Securities (ABS) may also be attractive to investors looking for a short-duration alternative.
— The Fed’s rate-hiking regime has affected Mortgage-Backed Securities (MBS) dramatically, leading to deep discounts. We favor higher-coupon issues, as they are likely to perform better if volatility continues, but we also recommend buying call protection on these issues.
— Putting it all together, we believe the market is pricing in a significant amount of uncertainty, especially regarding monetary policy. In this environment, we favor a barbell strategy.

The bond market posted deep losses in 2022 as the Federal Reserve continued its efforts to rein in the highest inflation rates in decades. But as investors began to anticipate some kind of end to the Fed’s tightening policy, risk assets showed signs of recovery at points. This momentum carried over into early 2023, and investors are finding attractive risk-adjusted opportunities in several segments of the core fixed-income market…something that has not been seen in a number of years.

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