Gautam Khanna | Source | Head of US Multi-Sector Fixed Income at Insight Investment

What does the “Inverted” Yield Curve mean for investors?
An inverted yield curve only really implies that rates are likely to be lower in the future than they are today. Classically it is said that it signals a recession. It can merely signal an economic slowdown at worst.
Consider that the Federal Reserve has deliberately raised rates to economically restrictive levels to contain inflation. All else being equal, once it slays the inflation demon, it makes sense that the central bank would look to bring rates back down to more “neutral” levels, regardless of whether a recession or (merely a slowdown) took place.
The Fed’s estimate of the neutral rate is 2.5%, which is not only a long way from the current Fed Funds rate of 5% to 5.25%, but also lower than the 3.7% low that the yield curve projects rates to fall over the next 10-years. To us, this indicates more of a “normalization” than policy “easing”, which may not imply a recession.

Is an “Inverted” Yield Curve a reliable indicator of an approaching Recession?
Historically, an inverted yield curve has been a solid, although not foolproof, predictor of a recession. Although a slowdown appears unavoidable, we would not see a recession as a guarantee.
But even if there is a recession, the yield curve offers little signal as to whether it would be a deep or shallow one. The good news, in our view, is that we believe any recession will likely be shallow. The economy is starting from a position of strength, consumer and corporate leverage is historically conservative and nominal GDP growth is robust at 5.4%. Rather than 2008 or 2020, think of a milder recession like the 1940s post-war downturn or something like the 2001 recession, during which real GDP did not actually decline on a cumulative basis.

How do you adapt to the Yield Curve with a Core Plus strategy and/or portfolio construction?
People tend to buy fixed income for two things: income and diversification. Therefore, we see two main themes to consider at present.
The first, is to make the most of high yields at the front end while they last to target compelling income. Higher spread assets with shorter maturities can offer considerable value for security-selection focused investors as cashflow visibility can be excellent over shorter timespans.
The second is to invest in longer-dated bonds for diversification. As rates fall over time, they may gain value from the “duration effect”, depending on where on the curve you invest. Further, we believe the inverse correlation between bonds and equities has returned, meaning duration exposure offers diversification against your riskier allocations like equities. Fixed income is potentially valuable “ballast”, stabilizing your overall portfolio during “risk-off” periods.

What are your broad views on fixed income as this curve inversion continues to deepen?
We believe investors need to avoid being swayed by media coverage of the inverted curve and consider that falling yields over time is to be expected given current Fed Funds rates.
We also believe now is the time to invest in fixed income and consider extending duration. Times have changed, fixed income now offers compelling yields after years at the zero-bound. An inverted yield curve implies the rate cycle will turn at some point, so now is a good time to start locking in those yields.
Also, fixed income currently offers a healthy balance of Treasury yield and credit spread. This may present an attractive entry point as it can offer a potential buffer against markets moving in either direction. During risk on markets, investors could benefit from spread tightening and during risk off markets could benefit from yields falling.
We believe investors should consider both duration exposure and high income attractive. Nonetheless, we believe careful security selection will be crucial for maximizing value and navigating the environment.