The Outlook for Income: Balancing Rates and Credit in 2023

When we think about generating income for our clients, for over 30 years we’ve thought the most efficient way to do this is to blend the two key risks of fixed income into one portfolio. The two key risks of fixed income are interest-rate risk and credit risk, and there typically we invest in high yield. The attractive function of that is it’s a very liquid portfolio.

The range of outcomes in 2023 seems to be a little bit larger than normal, meaning if inflation continues to surprise to the downside, capital market returns across the board should be very strong for the rest of the year. Now, of course, that’s a big “if.”

The Federal Reserve is highly focused on inflation being higher than their long-term target of 2%. And the longer it takes for inflation to come down to that target, the probability of recession in 2023 or beyond continues to increase.

The interest-rate-sensitive sectors in the US are slowing, the largest one being US housing. Housing has slowed for the last six to eight months here, and will likely continue to slow. Certainly not the end of the world, but again, until the Fed begins to relent, or until the Fed feels a little bit more comfortable that core inflation is moving towards 2%, the probability of recession is rising in the US.

In that type of scenario, we tell clients to focus on improving liquidity, lean into US Treasuries. High-quality high yield still offers attractive upside, or attractive carry, for the near term, but you probably want to be a little bit more defensive with assets that have much more potential default risk or drawdown risk.