Why fixed income is looking 'rather attractive' given potential recession risks

The fixed income sector could contain growth value ahead of the Fed's anticipated balance sheet roll-offs and a potential recession. PIMCO Managing Director and Portfolio Manager Sonali Pier believes equities would "bear the brunt" of any recessionary headwinds and encourages a pivot to fixed income in case of a disappointing earnings season.

Video transcript

JULIE HYMAN: Well, this earnings season is the latest test for the market's impressive year-to-date rally amid headwinds from near-future recessionary fears. So in the face of a possible downturn at some point, what's an investor to do? Our next guest finds that smart play lies outside equities.

With more, we're joined by Sonali Pier, PIMCO managing director and portfolio manager. Sonali, thank you so much for being here. So investors who are facing down this earnings season-- and there is a lot of noise around it, right, about concerns over falling profits overall-- where should they be looking in the corporate bond stack to take advantage of maybe riding their way out through the earnings season?

SONALI PIER: Thank you for having me. Yes, we think that investors can find value in high-quality fixed income, be that securitized, investment grade, and even some parts of the high-yield market. So specifically looking at agency mortgages, valuations have become much more attractive especially as the Fed allows balance sheet roll-off there. Within investment grade, these are high-quality companies where bankruptcy is quite remote and offering a good starting yield.

- So speaking of the-- you say a starting yield. Can it beat the return on equities right now?

SONALI PIER: No, and that's what's really interesting. And I think a key takeaway is that versus the long-term equity returns, fixed income is looking is looking very attractive, right, with much less volatility. And should we hit a recession, equities would likely bear the brunt of that.

So versus a long-term equity valuation, fixed income is looking rather attractive. And as we have given our preference in high-quality fixed income, that should outperform in a recessionary environment.

JULIE HYMAN: Are there particular areas that you're looking there within particular sectors, for example, within high-quality fixed income that are attractive right now?

SONALI PIER: Yeah, certainly. So agency mortgages have really widened and become more attractive in part because of the lesser footprint of the Fed, and we do tend to prefer the higher coupons there. Within investment grade industries, we tend to prefer some of the non-cyclicals such as utilities, as well as, I think, in financials, especially given what we've seen this year with the regional banks and the like, it's much more nuanced in terms of what part of the capital structure and which financials.

And then, as we go lower in quality, you know, preferring areas where we think cash flows are much more predictable and avoiding some of the sectors that have low margins, low multiples, and will struggle through an inflationary environment as well as an environment where we may see lower stock market levels.

- So when you say lower-end quality, what does that mean outside of, like, agency mortgage? Like, where are we talking about?

SONALI PIER: Certainly. So the health of the high-yield market has actually improved over the last decade as some of these risks shifted to the bank loan market or the private credit market. So that's not to say that all of-- this is definitely an area today with high dispersion.

And so, we're certainly taking a keen eye with our research analysts looking for-- looking at industry selection, security selection quite specifically. But, you know, what I would say is should we hit a recessionary environment, there will be more opportunities in the bank loan and private credit space. But today, we see the fundamentals of high-yield as being a bit more robust.

- And you said should we hit a recession. So should we hit a recession, there is the potential for some defaults, right, by some companies on their debt. So I guess I would ask, what is the default rate on debt look like should we hit a recession?

SONALI PIER: Yeah. Certainly, it'll pick up from the low levels that we've had more recently. But we're still forecasting high yield to have a default rate of, call it, 3% to 5%.

And the reason it's relatively low and it includes the long-term high-yield default rate is really because companies have turned out their debt in the-- after the Fed had stepped in during the great-- during the peak COVID experience that the subsequent 18 months, the back half of 2020 and throughout 2021, there was significant issuance.

And given the low level of rates at that time, they really turned out to their debt. But only 18% of high yield is coming due over the next three years, which certainly helped subdue the default rate.

JULIE HYMAN: Sonali, there's an interesting story on Bloomberg today that says that this may be as good as it gets when it comes to corporate bonds, that there has been this rally in the first half of the year, but that the spread over government debt is pretty low, and there are concerns about how much it can be sustained. Is that why-- first of all, do you agree? And do you think then that means that corporate bond investors are going to need to be more selective going into the second half?

SONALI PIER: You know, from our perspective, it's always about active selection between industries, between securities within the capital structure, and we're always looking to take advantage of dislocations. That said, with respect to fixed income, spreads have rallied from a credit perspective. However, even if credit spreads were to widen on the margin, the starting level of income due to these level of yields helps bear some of that, and so, potentially positive returns even with some spread widening.

- And Sonali, I want to ask you about-- let's say, there's more volatility to come, who's pricing it better? Is it fixed income? I think you probably have a strong opinion on this. Or is the equity market pricing and volatility better?

SONALI PIER: Right. So I think with where equities are today and with the potential for a recession, just on a look-ahead basis, there's much more downside protection in fixed income than there is in equities, right? So from that perspective, given the current coupon and current yield that you'll generate in fixed income as you wait for the recession or as it comes, there's definitely more downside protection in fixed income and still the ability to participate in some of the upside.