Getting to the Core of U.S. Bonds

George Bory: I'm George Bory, chief investment strategist for Fixed Income at Allspring, and welcome to SpringTalk. Today, I'm here with Maulik Bhansali, co-head of the Core Fixed Income team at Allspring. Maulik, thanks for joining us.

Maulik Bhansali: Thank you, George.

George: Maulik, the title of today's call is Getting to the Core of U.S. Bonds. So, let's just jump right in. You and your team, you manage three types of strategies, all built around the core of the fixed income market. You have short duration strategies, intermediate dated core-focused strategies, and long end strategies that really focus on credit. And it's with this type of exposure that you have really good visibility across the entire fixed income landscape. So, I guess just to kick it off, can you talk a bit about the macro environment for bonds right now?

Maulik: We think it's a great macro environment for bonds. There's a really good combination of factors in play that are supportive for investment-grade fixed income markets. First, we've clearly hit the end of the hiking cycle, barring some really unexpected data going forward. The last Fed (Federal Reserve) meeting really emphasized this. I mean, we have had stickier inflation, but the longer-term trend of disinflation seems to be intact for now and yields are high enough to provide a bit of cushion against some modest surprises. Recent rate increases have returned investment-grade yields to levels which are competitive with and, in many cases, more attractive than cash. Second, economic growth has been stronger than expected, but it is decelerating. The labor market is showing signs of slowing down, which is a key ingredient for stabilizing fixed income markets. And lastly, the Fed has materially reduced the scope of quantitative tightening. So, its balance sheet will contract at a much slower pace. This should keep the risk of liquidity issues in our markets contained. So, if you put all of those factors together, it paints a pretty constructive picture for fixed income markets.

George: How about just a quick thought on inflation? You mentioned growth is decelerating inflation. You said it's kind of sticky. What's your view? What's the team's view on inflation and how that trajects over the course of this year?

Maulik: Yeah, I think we do believe that inflation will remain persistent. The areas that have kept inflation sticky, like rents, don't really show significant signs of decelerating at the moment. That said, though, it's hard for us to envision an acceleration of inflation and we do think that in the longer run, the trajectory is downward. So, I think it might take longer to get to where the Fed wants to get, but we do think they will get there eventually.

George: OK, great. Like you said, it sounds like a fairly good macro backdrop. Decelerating growth, sticky but sort of declining inflation, and as you mentioned, a fairly tight policy from the Fed. How about some risks? As we think, you've got a lot of things going on both domestically and internationally. Are there any risks that keep you and the team up at night as we think about the remainder of this year and as we go into next?

Maulik: Well, I definitely think the number one risk is that inflation actually is worse than sticky. It actually accelerates. And I think that's a very low probability event. But it's definitely something that would change the environment considerably for bonds, generally. Another risk to watch out for is the fiscal picture. Fiscal deficits remain really high. We have an election coming up in a few months, which could change that trajectory again. And there's always the risk that there's just too much bond supply with the deficit picture. So far, we're not seeing any signs that the market can absorb that level of supply, but that is a risk that we're watching out for. And then, the last thing that we're always watching for is that this higher-for-longer environment uncovers some unanticipated problems, similar to what we saw with the regional bank crisis about a year ago. Markets are keenly aware of some of those risks, like commercial real estate, etc., but there's always the chance that something that nobody thought of could pop up as rates stay higher for longer. So, those are all the things are out there that could influence markets going forward.

George: And you make some great points, especially like, there are some meaningful risks out there. But yields are relatively generous. So, at a high level, if we think about the Allspring message and what we've been telling clients is we've really been emphasizing that investors, bond investors, should ride the curve. Pick your spot, find out where the right spot is for your portfolio. But when you think about the portfolios, when you think about the strategies in your group, how are you trying to take positions or try to position a portfolio to balance that trade-off between good favorable economics, relatively high yield, but kind of some clear and present dangers, if you will, that stare bond investors in the face?

Maulik: Yeah, we don't necessarily make duration or yield curve calls in our portfolio, preferring to focus more on security selection as a driver of performance. That being said, being diversified across the entire curve and across sectors makes a lot of sense in this environment. We think sector allocations should remain pretty modest here. Spreads are on the tighter end of the range. But there's enough to like about the markets to warrant not being underweight anywhere. And I think we do want to maintain exposures across all of the key sectors we're invested in because there's a lot to do from a security selection perspective. We think the current environment is as good as it's been for a bond picker in many, many years.

George: So, when you think about security selection, though, spreads are tight. They're very tight. Are there certain sectors where the opportunity set is either broader or more rich, whether we think about either mortgages or asset backs or corporates or is the general view that security selection is generous in all sectors?

Maulik: I think that security selection opportunities are available across all sectors. Interest rate volatility remains very, very high. And I actually would say maybe it's not so much high as more normalized levels than compared to what we've seen over the past decade or so. When interest rate volatility is high, it's typically the agency mortgage sector that provides the most opportunities because that's the sector that's most exposed to rate volatility. And that's, in fact, the case where we're seeing the most opportunities in that sector. Spreads are still wide there because of ongoing supply demand issues. If you think about that market, the two biggest buyers have been the Federal Reserve and banks and both of those buyers have stepped away now from the agency mortgage market, which has created a lot of dislocations and a lot of really cheap bonds to take advantage of. That said, there are parts of that market you do have to be careful of with volatility as high as it is. There are pockets that just don't give you the type of valuation you need to compensate for that level of volatility. So, there's a lot to do in that sector from a security selection perspective. And spreads are wide, but you have to be pretty careful about where your exposure lies. Another spot that we think presents a lot of value is in the shorter duration part of the asset-backed securities (ABS) market. In the highest quality parts of that market, you're still achieving spreads that have not nearly recovered what they lost since the Fed started hiking rates. And if you compare that to the shorter duration part of the credit market, that market has really recovered everything it lost. So, there's a lot of value in that front end of consumer ABS. In credit markets, spreads are probably the tightest of the sectors we look at, but that kind of hides the fact that there's a lot of dispersion under the hood within credit. I'd highlight a sector like banks, for example, where spreads are still much, much wider than they were a couple of years ago, especially relative to other parts of the credit market. And you've also had a tremendous amount of new issue supply there. We had over $500 billion of investment-grade credit issuance in the first quarter of 2024 alone and that's the second biggest quarter ever. Whenever you have that level of supply, there's always attractive opportunities to take advantage of. So, I'd say that even though credit spreads are tight overall, there's still a lot to do from a security selection perspective.

George: Well, like we say across all of our portfolios, at Allspring, we like to build portfolios from the bottom up. So, it does sound like there's plenty to chew on for a good security selector in today's market. Now, let's just turn and pivot. Let's talk a little bit about our clients and our investors. How are different types of investors approaching today's market? Because we have both institutional, retail, and kind of the broad spectrum of clients. And what have your recommendations been to them? How are you suggesting that they position in today's market?

Maulik: Yeah, I think our diversified client base is really interesting because a lot of what we would recommend to clients depends on what their starting point is. So, for pension clients, for example, some of them are very well funded now, given what stock markets have done and where yields are now. Those investors are ready to de-risk and really add more into the longer duration parts of the credit market. And so, I think there's a lot of opportunity there to be very active across fixed income, across the curve, generally. For other institutional investors, we've seen a big shift over the last several years of assets into things like private credit, private equity. These tend to be more illiquid investments. And that made sense when yields were as low as they were because those were spots where they could achieve higher yields. Now, with the higher quality investment-grade liquid markets offering what they are, I think there's a real opportunity to dial some of that movement back and achieve higher yields in higher quality and more liquid parts of the market. So, we're certainly seeing a shift in that direction to more public markets, away from private markets for those types of investors. And then, lastly, for the retail investor, I think the question has been more when to enter or extend duration, relative to cash holdings. And I think with rates having gone up as much as they have to start this year, this is the perfect time to do that because we're now achieving yields across the curve that are highly competitive or even better than, in some cases, cash yields. And so, it gives retail investors the opportunity to lock in higher rates and also get a little bit insurance policy with adding duration in case something really unexpected happens on the macro front.

George: Well, Maulik, I think you got us to the core of the U.S. bond market. So, thank you very much. It was a great discussion. Really appreciate you joining us today.

Maulik: Thanks a lot, George.

George: And for our audience, we’ll see you next time on SpringTalk.

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