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This is an excerpt from our 2023 Investment Outlook, in which specialists from across our investment platform share insights on the economic and market forces that we expect to influence portfolios in the year to come. This is a chapter in the Bond Market Outlook section.
First, the bad news: Global fixed income markets have undergone an extremely challenging 2022, with historically negative stock/bond correlations breaking down and leaving even diversified investors with seemingly no place to hide. Indeed, many credit market segments have posted dismal year-to-date performance, stemming from a combination of sharply higher government bond yields and wider credit spreads as the US Federal Reserve (Fed) and other global central banks have aggressively tightened monetary policies in an effort to rein in persistent inflation.
Now the good news: While this year’s economic and market turmoil has led to negative total returns in most fixed income sectors, the widespread sell-off and continued volatility have also created some attractive opportunities for discerning credit investors with longer-term time horizons.
I believe higher-yielding and income-seeking fixed income strategies – including well-run multisector credit portfolios – have the potential to act as powerful buffers against future interest-rate and credit-spread volatility. In particular, strategies designed to generate yield and total return in a risk-controlled manner by aiming to take advantage of the credit market dislocations that I anticipate going forward might be well worth considering. To further help exploit such market moves, many fixed income investors may wish to adopt a more defensive risk posture heading into 2023 and to preserve significant cash/liquidity stockpiles in their portfolios.
Despite looming (and growing) economic recession risks, I see several potential opportunities in higher-yielding credit sectors (Figure 1).
In aggregate, our predictive cycle indicators currently suggest that the global economy will likely enter a recession in 2023. However, it is not yet clear whether a mild recession would be sufficient to bring services inflation down to more manageable levels, or if we might be in for a much more severe economic downturn. In any case, I believe this year’s heightened uncertainty and volatility – which have contributed to different credit sectors selling off to varying degrees and at different times – have spawned opportunities to rotate across the global fixed income spectrum and to shift credit risk to areas that may offer compelling risk/reward trade-offs. Notably:
Bottom line: I expect there to be numerous relative-value opportunities for fixed income investors to judiciously add credit risk at potentially wider spreads in 2023.
While the deteriorating macroeconomic backdrop and challenging liquidity conditions appear to paint a dire picture for corporate bonds, I believe the bearishness is tempered somewhat by relatively attractive valuations, still-strong fundamentals, and a lack of imbalances compared to past credit cycles.
I acknowledge that monetary policy indicators, which have historically been a reliable predictor of credit market returns, look quite poor these days. Moreover, current credit spread levels, which are wide versus their historical medians across most fixed income sectors, already seem to reflect an impending slowdown in global economic activity. On a more upbeat note, corporate balance sheets appear very healthy to me overall, while many of the weaker individual credits in the market already defaulted during the early stages of the COVID pandemic.
Again, I believe many investors may be well served by building portfolio positions around various dislocations in higher-yielding credit markets, with a goal of pursuing yield and total return in as efficient and risk-aware a manner as possible. I also think it is important for investors to stay flexible and nimble with their portfolio allocations in an uncertain market landscape. Among other things, that might mean having sizable allocations to cash and liquid, developed market government bonds to be able to capitalize on market opportunities as they arise.
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