- Fixed Income Portfolio Manager
United Kingdom, Professional
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When I published my 2023 credit market outlook back in October 2022, I advocated for a defensive portfolio risk posture amid growing recession risks, while still preserving sufficient cash/liquidity to take advantage of anticipated market dislocations. Following a rally in many market segments, I’ve observed a shift in credit risk and sector rotation opportunities.
While I still favor defensive positioning from a tactical perspective, in the wake of last year’s sharp rise in yields, I believe higher-yielding credit sectors overall appear attractive over a three-year investment horizon and are trading close to their median spread levels as of this writing.
Don’t count on a soft landing
Since my last outlook, many areas of the credit market have rallied on optimism that moderating inflation would soon enable central banks to pause their rate-tightening campaigns. Following a decline in government bond yields and a compression of credit spreads, certain fixed income sectors look less attractive today than they did a few months ago.
Is the optimism warranted? I fear not. In my view, economic risks have not dissipated, and many developed market central banks appear more steadfast in their resolve to tame persistent inflation. Some of the credit market indicators I monitor have indeed improved at the margins, including rosier corporate management outlooks and declining commodities prices. But the monetary policy regime remains a headwind, and I suspect it will be very challenging for central banks to engineer a soft landing. Still, I see several potential opportunities in select higher-yielding credit sectors (Figure 1).
Figure 1
Where are the opportunities?
While I maintain a bias toward defensive positioning, I continue to see opportunities to potentially add value by selectively increasing credit risk and rotating among credit sectors.
Previously, some of the most attractive opportunities could be found in European contingent convertibles (CoCos), credit risk transfer (CRT) bonds, high-yield credit derivatives, and emerging market (EM) corporate bonds. Today, I see more compelling value in US non-agency residential mortgage-backed securities (RMBS), European credit and banks, and high-yield EM corporate bonds.
- RMBS: Housing data, including affordability of new homes, have deteriorated significantly over the past year, driven in part by substantially higher mortgage rates. But the tailwind of low housing supply, combined with record amounts of homeowner equity and conservative underwriting standards, create a favorable backdrop for housing fundamentals. I believe most seasoned bonds have accumulated enough structural support from embedded home-price appreciation and previous prepayments that they can withstand meaningful home-price declines. Within RMBS, CRT bonds look particularly attractive.
- European corporate bonds: I still favor CoCos and expect these issuers to remain resilient, despite the headwinds posed by the ongoing Russia/Ukraine conflict and potential stagflation (high inflation together with low growth) later this year. In addition, European investment-grade corporates appear to offer better value than their US counterparts, given a significant spread advantage.
- High-yield EM corporates: Spreads for emerging market high-yield corporates have rallied to a lesser degree than their investment-grade counterparts and stand to potentially benefit from improved cash flows and lower debt loads. Investors may want to focus exposures on companies with prudent balance-sheet management within the oil & gas, telecom, utilities, and infrastructure sectors.
Bottom line: Stay nimble
To be clear, I still believe credit market volatility and challenging liquidity conditions in the coming months could offer entry-point opportunities that are more attractive than I am seeing right now. It’s premature for central banks to “declare victory” over inflation, and I suspect we could be in for additional market volatility going forward. Accordingly, investors should be ready to move quickly if they wish to exploit market inefficiencies and credit dislocations that may arise, whether induced by central bank actions or by sudden, unanticipated market events. Above all, stay nimble.
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