How much further can yields and spreads go?
The magnitude of the recent market moves has no doubt been painful for many fixed income investors but becoming a net seller at this point would merely crystallise losses when, in our view, it is likely that over time these losses will be reduced as markets recover. Moreover, carry should mitigate some of those losses going forward.
In the meantime, we view entry levels across the fixed income sector as now becoming attractive, from both a yield-to-worst (YTW) and an option-adjusted-spread perspective. This is not new — entry points from a YTW perspective have been high for the past few months, but as one of the better longer-term predictors of return, it is worth highlighting. Spreads across Europe, the US and the UK are also now above their long-term averages. European credit has experienced the most significant spread widening out of this complex, with corporate spreads now over 100 basis points (bps) higher than they were at the start of 2022, while US and UK spreads have widened around 60 bps over the same period.
However, yields and spreads will not rise indefinitely; at some point, there will be a natural settling because the economy won’t be able to withstand higher rates without falling into a major recession. Given recent market developments, including the inversion of the US yield curve, we believe that there is a substantially higher risk of a recession next year, and that most economies will slow further during the remainder of 2022. Against this backdrop, we believe now is an appropriate time to start locking in the elevated yields and spreads that we are seeing, especially in Europe, where the moves have been the largest.
Bottom line
Looking ahead, we believe global credit markets will experience more dislocations due to a reduction in liquidity as we move from an environment of “too big to fail” to one of “too big to trade.” We also expect more volatility within global markets, both when moving into and out of cycles. In our view, this combination of lower liquidity and higher volatility will increase the opportunity set for longer-term global credit investors with solid top-down and bottom-up security- and sector-selection processes. Investors willing to look through the short- to mid-term volatility to invest at today’s elevated yield and spread levels can potentially benefit from increased idiosyncratic dislocations via security selection, increased market cyclicality via sector allocation and the solid total returns we expect from fixed income markets over the next several years.
1 Sources: BofA research; Bloomberg. The US market size is the sum of the ICE BofA US Corporate Index’s and the ICE BofA US High Yield Index’s face value.