- Fixed Income Portfolio Manager
United States, Intermediary
Change
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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.
Exploiting credit market dislocations and volatility
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.
Finding opportunities in higher-yielding credit sectors
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:
- European contingent convertible (CoCo) bond spreads have widened significantly of late and now imply a much worse future default scenario than I think is likely to be realized. While the ongoing Russia/Ukraine war has resulted in a worrisome global energy shortage, it has also given some European governments “cover” to support their economies via fiscal stimulus measures and to ensure that their nations’ banks remain solvent.
- Credit risk transfer (CRT) bonds that are backed by residential mortgages have come under pressure amid concerns around potential home price depreciation in the period ahead. However, many underlying homes have already experienced significant price appreciation in the seasoned deals, potentially providing a cushion against any declines. In addition, credit enhancement has made even the lower-rated CRT tranches very default-loss-remote, in my view.
- High-yield credit derivatives are trading wider than their issuer-matched cash bonds, a phenomenon not typically observed in non-recessionary environments. These instruments are also among the most liquid vehicles through which to gain credit exposure, better enabling allocators to swiftly adjust their portfolio risk profiles at relatively low transaction costs.
- Emerging markets (EM) corporate bonds have borne the brunt of today’s tighter global financial conditions. That said, deep country-by-country analysis and differentiation are paramount in this space, as is relative-value security selection on an issuer-by-issuer basis. Broadly speaking, I believe EM corporate fundamentals continue to look attractive, particularly within the oil and gas, telecommunications, utilities, and infrastructure sectors.
Figure 1
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.
Maintain slightly below-average risk profile, above-average liquidity
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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