MFS® Active Fixed Income: Pursuing Consistent Through-Cycle Alpha

Hello, my name is Alex Mackey, Co-Chief Investment Officer of Fixed Income at MFS^® Investment Management. Today, I’d like to share with you defining attributes of MFS’ active fixed income solutions and how these are informing our assessment of the opportunities and risks for global fixed income investors.

Q: What are the strengths of MFS’ active fixed income approach?

For more than half a century, MFS has been actively managing fixed income portfolios.

We develop deep insights for investment opportunities and risks through prioritizing fundamental research across global fixed income sectors, industries and issuers. 

Our portfolio management teams and analysts operate in a highly connected manner through our global research platform, which facilitates seamless collaboration and real-time information sharing across fixed income markets and asset classes, more broadly. This unified global investment framework ensures a diversity of viewpoints and underpins our relative value analysis across diverse economic and market environments, policy regimes and valuation relationships.

Our bottom-up investment views are supplemented with our assessment of top-down global macroeconomic conditions, enabling us to both contextualize sector and issuer-level credit analysis as well as to develop conviction regarding long-term, through-cycle investment trends and opportunities. 

Portfolio risk budgeting and ensuring a diversified allocation of portfolio risk across rates, regions, sectors and issuers serves as the foundation of our investment philosophy and process.

We calibrate risk to align with our level of conviction regarding market opportunities, driven by our assessment of both investment fundamentals and valuation. The risks we assume in our portfolios are intentional and prudent, and we rigorously and continuously measure and monitor to ensure alignment to risk targets.

We apply a highly disciplined, long-term horizon to budgeting risk, relying on deep research-based conviction while maintaining flexibility to exploit short-term market volatility. We resist the search for short-term gains associated with poorly compensated risk.

At all times, we focus on aligning portfolio risks to investment strategy targets and client expectations, thereby providing our clients with transparent and reliable fixed income exposure in the context of their overall investment framework.

Q: How do you assess the current macro environment? And what is your outlook for the fixed income market?

Fundamentally, we anticipate that the global economy will generate moderate growth along with gradually declining inflation as it continues the transition from pandemic-created conditions to a return of longer-term secular trends. 

Most major central banks have likely reached the end of their rate tightening cycle, with a number having already started to lower rates in response to loosening labor conditions and inflation levels approaching — but not yet reaching — long-term policy targets.

Within this context, however, we view important regional fundamental and policy-related distinctions that reinforce the importance of active risk allocation.

US Macro Environment
The US economy has exhibited some signs of slowing; however, growth remains moderate and supportive of credit markets, led by strong corporate and consumer balance sheets, resilient consumer spending, continued labor market expansion and wage growth. We are sharply focused on the lagged effects of higher interest rates and inflation on these economic pillars of support.

Following higher-than-expected observed inflation earlier this year, a growing breadth of data suggest that price pressures are moderating in labor, goods and, importantly, in the more recent service sector observations of the economy. We believe that these trends will ultimately support a Federal Reserve which may reduce short-term rates, although the Fed will trail the timing of many of its developed country peers.

Given the ongoing breadth of economic support and uncertainty with respect to the timing of future monetary policy changes by the Federal Reserve, we believe that a close to neutral interest rate duration position is warranted in the US.

We believe that, in the US as well as other regional credit markets, risk premium or credit valuations have become more challenging. Risk premiums have narrowed significantly over the past year and are historically low. As a result, we believe that it is prudent to be positioned closer to the low end of our strategic risk budget and to further emphasize defensive and highly durable through-cycle credit exposure.

Europe Macro EnvironmentThough the European economy modestly rebounded during the first part of this year, overall activity continues to stagnate, led by weakness in manufacturing, bank lending and consumer spending.

We expect declines in inflation to continue, led by food and non-energy industrial goods. As is the case in the US, service price inflation has been persistent, but should moderate with a cooling labor market.

Europe is our favored region in which to take active long duration risk. The European Central Bank has already shown its willingness to cut rates ahead of the Federal Reserve given the relative economic disparity between the two regions.

We have a preference for sovereign bonds across Europe’s periphery, with a view that countries such as Greece, Spain and Portugal are benefiting from EU program support, exhibiting lower deficits than core countries such as France, requiring less net debt issuance along with the benefit of rating agency support. Despite the recent outperformance of European corporate debt relative to that of the US, we continue to believe that this sector offers attractive relative value on a global basis. 

Japan Macro Environment
In Japan, we expect the Bank of Japan to continue to normalize interest rates toward a terminal rate of 0.5% in combination with a gradual taper of quantitative easing. We believe that the BOJ is carefully balancing the positive role rising rates would play in promoting additional bank lending with the risks that higher rates could thwart their ultimate objective of attaining a 2% inflation target. 

While this shift away from ultra-loose monetary policy is not seemingly supportive for fixed income investors, yield curves are steep, which provides attractive relative value for Japanese government bonds on a globally-hedged basis and should support the market in our view. We expect further support from strong investment demand by Japanese banks, especially in the longer 10-year part of the yield curve.

Emerging Markets Macro Environment
For emerging markets debt, we believe that the current global backdrop of resilient economic growth, which is “neither too hot, nor too cold,” is fundamentally supportive. Such an environment produces aggregate demand to support developing country exports while allowing for moderating global rates, placing less stress on developing currencies and dollar repayment obligations. On balance, relatively high developing country growth and robust external balances underpin stable to improving credit quality.

Many developing countries raised interest rates prior to developed country central banks and now are experiencing broad disinflation. Despite many countries having already started to cut rates, policy levels remain restrictive, with room for further rate declines.

As in developed markets, credit spreads are at historically tight levels, creating a challenging environment in which to find attractive opportunities. We are being selective and focusing on high quality, stable, sovereign and corporate issuers with durable credit fundamentals.

We continue to focus on adding local rates exposure where the economic fundamentals and monetary policy support further rate cuts. We are maintaining modest exposure to some high carry emerging markets currencies, while avoiding those where we believe the central banks will cut rates quickly.

We believe that structural growth challenges will continue to persist in China. We are underweight local and dollar-denominated sovereign debt as well as the currency, which should remain under pressure from fundamental conditions.

We are sharply focused on broad-based risks across the emerging markets debt sector, including impacts from regional geopolitical conflicts in Eastern Europe and the Middle East, the potential for policy changes resulting from recent elections, and a challenging technical environment due to the continued outflow from emerging markets debt bond funds.

Are we at the point where investors should reconsider the allocation to fixed income?

We believe that the outlook for fixed income investors is positive when considering prospective returns as well as providing effective diversification to equities within multi-asset investment frameworks.

Starting yields are an important determinant of long-term returns for fixed income investors. In the current environment, investors can potentially realize both attractive nominal yields as well as capturing significant real rates of return.

As we’ve already discussed, with global inflation softening, the likely broad direction of global monetary policy will be toward accommodation, thereby offering investors the potential opportunity for additional returns through capital appreciation. 

While cash investments currently offer higher yields than longer-term bonds across developed markets, we believe that it is prudent for investors to adopt a time frame consistent with their investment objectives when considering the optimal maturity structure of their fixed income portfolios. Negatively-sloped yield curves suggest that the marketplace does not believe that the current level of cash returns are sustainable longer term.

Despite this positive backdrop, there are important broad-based risks facing fixed income investors.  Further progress to reduce inflation is required for global monetary policy to become broadly more accommodative. This may prove to be more difficult than expected. Fiscal deficits across key markets creates greater supply of government debt the market must absorb and reduces future flexibility to backstop economic weakness. Geopolitical risks across the globe are numerous and the impact of elections on policy may undermine sound economic principles. And, as discussed earlier, risk premiums for credit investors globally are historically low, providing minimal cushion to any credit quality deterioration resulting from broad-based economic slowing.

Conclusion

At MFS, we believe active fixed income solutions provide the opportunity to capture through-cycle alpha. MFS delivers active fixed income solutions which benefit from three key characteristics we see as essential to seeking alpha and a client experience consistent with expectations.

First, MFS fixed income solutions benefit from a structurally connected, global organization focused on deep research, which contributes to deeper conviction in portfolio positioning.

Second, by applying a long-term focus to risk taking, MFS fixed income solutions are focused on avoiding poorly compensated risk while aiming to position to take advantage of market volatility and dispersion.

Finally, MFS fixed income solutions are governed by prudent and transparent active risk budgets, to clearly align portfolios with client’s goals and objectives.

Thank you for putting your trust in MFS.

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Investments in debt instruments may decline in value as the result of, or perception of, declines in the credit quality of the issuer, borrower, counterparty, or other entity responsible for payment, underlying collateral, or changes in economic, political, issuer-specific, or other conditions. Certain types of debt instruments can be more sensitive to these factors and therefore more volatile. In addition, debt instruments entail interest rate risk (as interest rates rise, prices usually fall). Therefore, the portfolio’s value may decline during rising rates. The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice. No forecasts can be guaranteed.

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