Looking Forward in Fixed Income

On the last day of the Milken Global Conference, a panel of asset managers representing practically the full spectrum of investable asset classes took to the stage in a discussion called “Reading the Tea Leaves: Where are Markets Headed?” And while the panelists discussed commercial real estate (pretty positive) and equities (mixed reactions), I’d like to focus on their comments on fixed income markets. One panelist drew the attendees’ attention to the low interest rate environment, the low inflation environment, and the low default environment, and suggested that this mixture was good for spread product (i.e. non-Treasury fixed income assets). A small majority of the panelists felt that the Federal Reserve would begin raising interest rates within the next 12 months, with one expecting some sort of move yet in 2014.

So, I’d like to compare those comments with a recent document that came out of the Principal Global Fixed Income team. This link will take you to a market bulletin that was released in April and explains an update to a risk-monitoring measure that the team uses to inform their portfolio construction process. The measure is called the Dynamic Risk Score (DRS) and it ranges from 1 to 10. On this scale, 1 represents the worst risk-taking environment and 10 represents the best risk-taking environment. In April, the team’s Fixed Income Strategy Group recommended tightening their market risk limits and lowered the DRS from 6 to 5, and as they say “We believe that in the current risk-taking environment, risk product [i.e. spread product] is likely to outperform U.S. Treasury securities over the next three to six months. We are tightening market risk limits in the event of increased volatility, but not recommending a reduction of risk positions at this time.”

So, broad agreement with what I’m hearing at Milken. Though, the fixed income team goes on to list three catalysts that could potentially push market volatility higher. I’d draw your attention to the first: profit margins. One of the participants in this morning’s panel pointed out that the current recovery has been the strongest profit recovery, but the weakest revenue recovery, meaning corporations have been doing a great job at squeezing more profit out of each dollar of revenue. The fixed income team has that in mind and the DRS report notes that “Profit margins have remained historically high since the recovery began, due to limited hiring, limited business expansion, and historically low interest rates. However, if companies misjudge earnings and begin to hire and expand too aggressively, this may reduce profit margins.”

If you’re interested, you can check out the Principal Global Fixed Income landing page regularly for updates to this interesting insight into their thinking on portfolio positioning. My next session is “The View from Institutional Investors,” so more insights in a few!



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