Wealth Management
A major theme of 2023 has been the constant compression in volatility. In fact, the volatility index (VIX) is now lower than when the bear market began in January of 2022 despite the S&P 500 being about 10% below its all-time highs.
However, the consensus continues to be that these conditions won’t persist for too long. The longer that rates remain elevated at these lofty levels, the higher the odds that something breaks, causing a cascade of issues that will lead to a spike in volatility and a probable recession. According to Vanguard, a shallow recession remains likely to occur sometime early next year.
For fixed income, it will certainly be challenging. So far this year, the asset class has eked out a small gain despite rates trending higher due to credit spreads tightening and low default rates. However, more volatility is likely if rates keep moving higher which would likely lead to selling pressure or if inflation does cool which would result in the Fed loosening policy, creating a generous tailwind for the asset class.
Given this challenging environment, active fixed income is likely to outperform passive fixed income as managers have greater discretion to invest in the short-end of the curve to take advantage of higher yields while being insulated from uncertainty. Additionally, these managers can find opportunities in more obscure parts of the market in terms of duration or credit quality.
Finsum: Fixed income has eked out a small gain this year. But, the environment is likely to get even more challenging which is why active fixed income is likely to generate better returns than passive fixed income.
UBS shared its outlook on fixed income and high yield credit in a strategy piece. Overall, the bank is moderately bullish on the asset class, especially at the short-end of the curve, but doesn’t believe returns will be as strong as the first-half of the year.
Overall, it attributes strength in the riskier parts of the fixed income universe to a stronger than expected US economy which has kept the default rate low. This has been sufficient to offset the headwind of the Fed’s ultra-hawkish monetary policy.
The bank attributes the economy’s resilience to lingering effects of supportive fiscal and monetary policy and the strong labor market. It’s a different type of recovery than what we have seen in the past where financial assets inflated while the real economy struggled.
However, UBS believes that the default rate should continue to tick higher so it recommends a neutral positioning. It also sees a correlation between equity market volatility and high-yield credit. While this was a tailwind in the first-half of the year, it believes that it should be a headwind for the remainder of the year given high valuations.
Overall, it sees a more challenging environment for high-yield credit and recommends sticking to the short-end of the curve to minimize duration and default risk.
Finsum: In a strategy piece on high-yield credit, UBS digs into its strong performance in the first-half of the year, and why it expects a more challenging second-half.
In a piece for AdvisorEdge, James Langton discusses how banks are tightening their lending standards which could present an opportunity for alternative investment managers. According to a report by Fitch Ratings, there is a surge in interest for private debt from borrowers. In North America, private credit funds’ assets under management increased from $242.7 billion in 2010 to over $1 billion at the start of the year.
And, this trend should only accelerate in the coming years especially as regional banks are a key source of funding, and many are struggling with an inverted yield curve. The crisis in regional banks earlier this year underscored their perilous position. Thus, it’s not surprising to see a flurry of new private credit funds. In the second quarter, 34 new funds were launched, raising $71.2 billion, more than double what was raised in the first quarter.
Private credit is more insulated from rising rates due to its reliance on floating rate-loans. Additionally, default rates have remained at historically low levels at 1.6% in Q2 and 2.2% in Q1, indicating that the overall economy remains resilient and rewarding investors in these funds.
Finsum: Funding from banks is increasingly difficult to access given tighter credit standards and challenges for regional banks. This is creating an opportunity for alternative investment managers as private credit funds step into the void.
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Although 2022 was the worst year for bonds in recent history, there are some silver linings for fixed income investors according to WisdomTree’s Andrew Okrongly and Behnood Noei who are the firm’s director of model portfolios and fixed income, respectively. These are the highest yields in decades which is bringing ‘income back to fixed income portfolios’ and the potential for significant returns. The second is reduced duration risk given that short-term bonds are offering generous yields.
The current environment is significantly different from what prevailed for much of the last 2 decades when bonds both trended higher with minimal volatility. However, the asset class became less appealing due to higher levels of duration risk in addition to miniscule yields. As a consequence, many fixed income investors went further out on the risk curve to find yield whether it was junk bonds, EM debt, or dividend-paying stocks.
Now, investors can find much higher levels of yield with much less risk. Therefore, fixed income can return to its traditional role of providing income and safety in portfolios. In fact, it’s a rare circumstance that shorter-term bonds are offering much higher yields than longer-term bonds with less risk. And, these conditions should persist given current Fed policy and the economy’s resilience.
Finsum: Investors should consider short-duration fixed income model portfolios given that they are offering higher yields with less duration risk.
LPL Financial topped earnings expectations in the second quarter as it reported $3.65 in earnings per share which exceeded analysts’ estimates of $3.47 per share. It was also an 85% increase from last year, primarily driven by higher rates. The company also had another strong quarter in terms of recruitment which the firm expects to continue in the third quarter.
In total, it added 421 new advisors in Q2 for a total of 21,942. Notably, this is more than a 5% increase on a year-over-year basis as it had 20,811 at the end of last year’s Q2. It saw an 8% increase in total assets, reaching $1.2 trillion with organic new assets of $22 billion and recruited assets of $19 billion.
According to CEO and President Dan Arnold, the company’s success was due to winning new clients, expanding ‘wallet share’, focus on servicing clients, and a differentiated experience. It also saw a 99% retention rate in the quarter, and the company continues to invest in new technology and new services such as direct indexing. It also announced the acquisition of Crown Capital which has 260 advisors and $5.5 billion in assets.
Finsum: LPL Financial announced its second quarter earnings results which topped analysts’ expectations in terms of earnings per share and asset growth.
We are seeing a flurry of active fixed income ETF launches over the past few months. While it’s nearly settled that with equities, passive tends to outperform active strategies, active fixed income strategies have performed better than passive fixed income especially in recent years.
Further, there is considerable uncertainty around the economy regarding rates, inflation, and a potential recession which could lead to more opportunities for active managers. Additionally, active managers have more latitude in terms of duration and credit quality.
Therefore, money is flowing into active fixed income ETFs from mutual funds and passive bond funds. For Barron’s, Lauren Foster discusses whether these inflows into active fixed ETFs will continue or is it just a short-term fad.
Money is likely to also flow into active fixed income ETFs from active fixed income mutual funds given that the ETFs offer several benefits such as lower fees, more transparency, and intraday liquidity. The younger generation of investors also tend to favor ETFs rather than mutual funds due to higher comfort levels and an understanding of how high fees can impact long-term performance.
However, the ultimate factor is whether these ETFs will continue to deliver strong returns relative to passive fixed income ETFs and active fixed income mutual funds. So far, they seem to be offering the best of both worlds to investors.
Finsum: A major theme in 2023 has been the rise of active fixed income ETFs. But, there is considerable doubt whether these will gain traction and are better than passive fixed income ETFs or active fixed income mutual funds.