Third Quarter 2023

Economic data has shown greater late-cycle strength than expected yet, forward indicators illustrate meaningfully slower activity. Our base case of an expected U.S. recession has been boosted by the Fed guiding markets to monetary policy staying restrictive well into 2024. U.S. Treasury yields have repriced significantly higher making headwinds to economic growth more forceful and elevating the risk of a policy error. Our concern with an extended period of tight monetary policy, is an increased risk of a more pronounced slowdown.

The move higher in U.S. Treasury yields reflects Fed policy as well as other concerns. Investors are considering supply challenges from greater than expected deficits which partly reflect the government’s own increasing interest expense. The market is also assessing future demand with questions about U.S. fiscal probity. These concerns are valid to explore, yet we do not believe they are durable drivers of yields. That said, with a potential disruption to U.S. Treasury operations being narrowly avoided for the second time this year, we acknowledge it can take time for investors to be reassured. We like duration here, but we are not taking significant overweights in portfolios until the upward momentum starts to fade.

We have maintained an overweight to credit throughout this cycle as corporate fundamentals significantly improved post pandemic generating strong credit metrics and valuations have ranged from being very attractive to fair. That investor-friendly profile is shifting as we move farther into this tight monetary policy period. Revenue growth is slowing as inflation decelerates. Leverage is picking up, driven by increases in debt and lower EBITDA levels. While we are encouraged by the discipline being shown with declines in buyback activity and lower dividend payouts, we are mindful that the overall fundamental backdrop is weakening. Technicals have been very supportive of corporate spreads, reflecting persistent inflows into fixed income and moderate supply. Valuations, as a result, have richened considerably, particularly for long bonds and BBB-rated bonds where supply has been the most constrained. In our portfolios, we are leaning into those names that we believe are well positioned to navigate a slowdown, which positions us to take greater advantage of wider spreads if they materialize. We are using credit as a funding source to reduce exposure for positions that have achieved our targets or where the fundamentals are less compelling.

Other fixed income sectors broadly present a greater opportunity to deploy capital. Market prices have already started to reflect some of the challenges that are in play leading to spreads that reflect, we believe, attractive compensation for the risk profile. An example would be MBS which, although hampered by the elevation of interest rate risk in the latter part of the third quarter, have a very attractive return profile with cheap valuations that we expect to perform well as Fed tightening ends. There continue to be opportunities in the non-agency CMBS space, particularly in newly underwritten deals where prices of the underlying loans more fairly reflect the stresses present in commercial real estate.


Past performance is not a guarantee or a reliable indicator of future results. Investing involves risk; principal loss is possible. Fixed income market data provided is drawn from the Bloomberg Indices for informational use only and is not representative of account performance. It is not possible to invest directly in an index. Investors should carefully consider risk when investing in bonds or other securities, which include, but are not limited to, default, credit rating, interest rate, duration, prepayment, liquidity, and structural risks. Securities are also subject to general market risks due to factors that affect the overall market, which may include, but are not limited to, government actions, investor behavior, and economic conditions. Economic conditions may be influenced by liquidity risk, geopolitical risks, monetary and fiscal policy, interest rate risk, and inflation, among others. There is no guarantee that investment strategies presented will work under all market conditions. Risk management processes including diversification cannot eliminate the risk of losses nor assure the likelihood of a gain. Each investor should evaluate their ability to invest for the long-term, especially during periods of downturn or volatility in the market. Refer to the Legal & Disclosures section for additional disclaimers and disclosures regarding performance, risk, and investment process.

Information presented is for informational purposes only. It is not intended as investment advice nor an opinion or a recommendation as to the appropriateness of investing in any particular security, asset class, strategy, or product. Nothing in this publication is intended to be relied upon as a forecast or research; legal, tax, securities, or investment advice. Nothing in this publication is a solicitation of any type.

This commentary contains Pugh Capital’s opinions based on the information available at the time of the analysis. Opinions, outlook, and strategies are subject to change without notice. Statements concerning financial market trends are based on information available and current market conditions which will fluctuate. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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Source: Pugh Capital, Bloomberg, and Bloomberg Indices.

As of September 30, 2023.