Chart in Focus: Compelling opportunities in four higher-yielding credit sectors

Despite looming (and growing) economic recession risks, we see several potential opportunities in higher-yielding credit sectors (as shown in below chart). While these excess return forecasts assume that spreads will revert to their historical medians, our slightly more bearish forecast incorporates some degree of spread widening given our expectation for an economic slowdown. In our view, some of the most compelling opportunities in fixed income credit sectors include:

• Additional Tier 1 European banks (AT1s/CoCos): Banks for which the trajectory of fundamentals remains positive and are trading below par, offer the potential for price appreciation if called by the issuer.
• Credit risk transfer (CRT) bonds: These securities continue to be supported by strong housing data releases and a favorable technical backdrop: Supply remains limited while investor flows have been positive.
• Agency mortgage-backed securities (MBS): Spreads on MBS have widened on the back of elevated rate volatility. MBS excess returns also tend to be less correlated with credit risk and hence add some diversification to credit portfolios.
• High-yield derivatives: Within high yield, one of our highest conviction ideas is the price differential between high-yield credit default swaps (CDX) and their underlying cash bonds. Compared to history, high-yield CDX offers an attractive relative spread advantage to cash.

Conversely, emerging markets (EM) USD-denominated sovereign spreads remain in the tightest quintile relative to history. As a result, we think it is prudent to consider reducing EM sovereign exposure in favor of the opportunities outlined above.

Figure 1