Today income is “IN” and the “INs” are interesting
The good news: Investors are finally earning attractive levels of income. However, today’s market presents many challenges and complexities that call for a thoughtful approach to building portfolios and navigating the current environment.
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The current market environment has been a challenge for many investors, traditional and alternative. Today, it is critical to bear in mind that the “ins” matter. Here we identify five key drivers – the “Ins” that have been keeping things INteresting for investors.
Income
INcome is in for the first time in two decades: Income levels are attractive. Yields are higher today than they’ve been in a long time. The relationship between higher yields and higher income is an obvious one, but we think it is important for investors to be thoughtful about their approach to earning income in their portfolios. This is because risk premia are actually very low across markets (more on this topic shortly). That means investors should think carefully about the tools they use to earn income and resist the urge to take on risk where the compensation for risk may be inadequate.
Inflation
Market surveys today list as top concerns, macroeconomic uncertainty, recession and geopolitical events. This is very different from a year ago when all the headline concerns were about INflation. As inflation has moderated across developed markets, many investors seem to have forgotten that it existed.
We do not think inflation has been completely tamed, and we expect that it will continue to contribute to noise and volatility. The market appears to be projecting 2 to 2-½ interest rate cuts by the beginning of next year, and while we think that may be possible, we aren’t sure it will be necessary – nor do we agree that neutral Fed Funds rates are 2.5%.
We think the market is overestimating the pace and the degree that interest rates can be made more accommodative without reigniting inflation or economic growth.
Exhibit 1: Inflation has reduced enough in Europe for cuts, and in the US has been “forgotten” as a risk
Sources: Bloomberg, FRED, Schroders Capital. 613135.
Actually, we are not really overly concerned with the impact of short rates at today’s levels (or levels higher than the market anticipates longer term). In our view, short rates have a more muted impact on US economic conditions. Very little US debt is linked to short rates, while the majority is linked to 5-year to 10-year (or longer) rates.
This is particularly true in the case of US consumer debt, little of which is linked to short-term rates, and almost all US mortgages are 30-year fixed rate mortgages with a majority locked in at a historically low rate like 3%. These US homeowners have built up enormous amounts of equity, which creates a wealth effect that we think will contribute to consumer spending and investment in ways that will be very different from what we’ve seen in the past.
Exhibit 2: Home equity has increased substantially in the US
It has NEVER looked like this: Homeowners have been huge beneficiaries of the growth in wealth
Sources: FRED, CoreLogic. As of Q3 2023. Shown for illustrative purposes only and should not be interpreted as investment guidance. 613135.
For corporate borrowers, the picture is generally the same, a large universe of corporate bonds is fixed rate, those will be sensitive to rates at the point of maturity. It is really only in revolving loans or in the below-investment-grade universe, such as direct lending or leveraged loans, that the debt is floating rate.
In the commercial real estate space, borrowers are struggling with near-term maturities that have forced them to refinance at much higher rates, and require cash-in. These borrowers are definitely feeling the pinch of higher borrowing costs. This means that the markets will be more sensitive to what happens to 5-year and 10-year Treasury rates than they will be to Fed Funds rates, and this seems to be different from what most investors expect.
Exhibit 3: Corporate borrowers are feeling the pinch of higher borrowing costs
Some hard lessons learned
Source: JP Morgan. 613135.
Inversion
We think investors should pay even more attention to the medium- to longer-term portions of the yield curve. In an environment where people seem to have forgotten about inflation and are yet somewhat optimistic about economic health (no recession), it seems a little odd that we have an inverted yield curve in nearly every developed economy except for Japan.
In a world of high short-term interest rates and comparatively lower intermediate to longer-term interest rates, investors are not being paid for taking duration risk in many parts of the curve.
In fact, the real pain point for many duration-adding investors is a scenario where the yield curve becomes more normally shaped, which could create negative outcomes for investors owning intermediate- to longer-term duration assets. From that perspective, we see real benefits from positioning at the shorter end of the curve where income is higher and duration risk is lower.
Exhibit 4: Yield curves are inverted in most developed economies
Yield curves: US, UK, EU and Australia
Source: Bloomberg, As of June 28, 2025, 3:50 p.m. Shown for illustrative purposes only and should not be interpreted as investment guidance. Forecasts may not be realized. 613135.
Insanity
There are extreme levels of FOMO (fear of missing out) in risk assets, which in turn has led to a severe contraction in risk premia, not just in public markets but also in some of the more traditionally accessible private markets. Credit spreads have continued to tighten. For many bonds and loans, the current risk premium seems to defy common sense and sanity.
Investment-grade corporate spreads have compressed to near-historic tights, as have below investment-grade instruments such as high yield bonds and broadly syndicated loans. Middle market loans, the private markets counterpart to broadly syndicated loans, have also witnessed a compression in spread levels and, in some cases, a watering down of lender protections.
As corporate borrowers have become more adept at pivoting between public and private markets in search of the cheapest source of capital – and as more investor capital has migrated to private credit firms – the yield premium generated by direct lending over public markets has narrowed.
Exhibit 5: Spreads are historically tight
Sources: Schroders Capital, ICE BofA. Shown for illustrative purposes only and should not be interpreted as a recommendation to buy or sell. 613135.
Securitized credit is also nearing historical tights, although we would note that securitized assets have generally offered more attractive pricing than corporate debt. More importantly, we think investors should consider securitized credit as a potential source of resiliency in a world where tight credit spreads provide little insulation from idiosyncratic risks. Even within securitized credit, not all bonds have the same risk profile for the same yield spread premium, as Exhibit 5 makes fairly clear.
Securitized markets were originally established to allow borrowers such as large corporations to access financing on a secured basis at a more efficient cost of capital than what they could achieve unsecured. Assets such as equipment or receivables were placed into a bankruptcy remote trust to reduce the risk of the issuer, and to allow for many, many receivables to be cross collateralized to ensure that there was a diverse exposure. This is an approach designed to mitigate idiosyncratic risk. If you believe that idiosyncratic risk is critical in the current environment, why not invest in a sector that was built around minimizing this type of risk?
Collateralized loan obligations (CLOs) are one example of how securitization can offer better investment outcomes. Looking at the historical record reveals that CLO debt has experienced meaningfully lower default rates than comparably rated corporate debt. Despite having better structural protections and diversification levels, CLO debt offers higher spread levels than corporate debt, which we see as a potential area of opportunity for those that want less exposure to volatility and more exposure to income.
We believe that agency mortgage-backed securities (MBS) are more attractive than they have been in a long time, particularly when we compare their spread levels versus high grade corporates. In a world of tight spreads and idiosyncratic risk, agency MBS offer a refuge, as shown in Exhibit 5, agency MBS is one of the only asset classes that is not historically cheap. They offer a way to build portfolio resilience while generating attractive income.
Exhibit 6: Annual global default rates: CLOs versus corporates
Sources: Default rates for CLOs and corporates include all rate entities. Corporates (speculative grade) include companies rated “BB+” and below. CLO = collateralized loan obligations. Source: S&P Global Ratings Credit Research & Insights and S&P Global Market Intelligence’s CreditPro®. Copyright © 2024 by Standard & Poor’s Financial Services, LLC. All rights reserved. Shown for illustrative purposes only and should not be interpreted as a recommendation to buy or sell. 613135.
Inefficiency
When central bank policies converge and liquidity is being provided, volatility is removed from markets. When these policies diverge, we expect to see an increase in volatility. Alongside increased volatility, we expect there will be a move away from a beta-oriented market into a regime when there will be opportunities to generate alpha by distinguishing good from bad within a sector or by finding inefficient markets.
However, it is important to be discerning about where to look for “true” inefficiency because efficiency has been steadily increasing in various corners of the more traditional private markets. For sectors such as middle market lending, this is a natural byproduct of greater capital inflows, leading to increased competition among lenders.
The effects of this can be seen as direct-lending spreads have increasingly converged with broadly syndicated loan spreads. In addition, we have seen signs that direct lenders have had to become more competitive as a source of financing, which in some cases has meant more borrower-friendly terms such as pay-in-kind structures or higher leverage.
From that perspective, it begs the question as to whether the direct lending space can still offer investors the benefits of inefficiency premia.
Exhibit 7: Behaviors are changing, as reflected by changes in CLO vs. private debt markets
Source: BBG, BofA, LCD. Shown for illustrative purposes only and should not be used as investment guidance. DL = direct lending. BSL = broadly syndicated loans. 613135.
A word on commercial real estate (CRE) debt
Commercial mortgage-backed securities (CMBS) have been in the headlines recently because of some high-profile impairments, in some cases at the AAA level. These impairments have occurred among a specific type of CMBS transactions known as “single asset, single borrower” (SASB) deals. These SASB deals are atypical among securitizations because they do not have diverse pools of loans, but instead have exposure to a single loan or borrower.
We recently released a more detailed article on this topic, but to summarize:
- Investors in CMBS single asset, single borrower deals need to re-underwrite the bonds as if they are making the loan directly.
- Investors in SASB deals cannot rely on diversification – they are exposed to the performance of a single underlying asset. As such, these deals are highly idiosyncratic.
- Investors should be wary of "tourist” traffic in this space, i.e. generalist managers who are starved for spread in the broader credit markets and decide to dabble in the CMBS markets as a way of boosting portfolio yield.
With that said, we think there is opportunity in the CRE debt space for managers with specialist expertise who can carefully underwrite underlying loan exposures and fully evaluate structural risk. However, the “adult swim” rules apply, and many investors may be unwittingly jumping into the deep end of the pool.
Ways to navigate today’s market
Filter out the noise and focus on the fundamentals. Don’t focus on individual economic numbers and don’t take risks you are not paid to take. In this environment, investors will be better served by focusing on the fundamentals of various markets and issuers, while looking for signs of durable shifts in markets that will create value for investors.
Take risks only where you’re paid to take them. With the current FOMO mindset, everyone seems eager to take on credit risk. But investors should be mindful of risks that are idiosyncratic and/or asymmetric.
Aim to take advantage of inefficiencies but carefully assess them. Investors should question whether markets traditionally considered inefficient remain so in the current environment. In market sectors where there is a lot of competition, it becomes more challenging to argue for inefficiency. Just because a particular market has been inefficient in the past, there is no guarantee that it is now or will be in the future.
Divergence in central bank policy is likely to bring more volatility. Globally, economic strength varies among countries – this will impact the rate paths of different central banks. As central bank policies diverge after decades of convergence, investors will need to shift from beta to alpha.
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