Fixed income 2023: Ripe for a reversal

There’s no sugarcoating it: Last year was rough sledding for bond investors. High-grade fixed income markets experienced their worst-ever calendar year in 2022,¹ driven by sharply higher sovereign bond yields as global central banks supercharged their rate-hiking cycles in an effort to rein in persistent inflationary pressures (Figure 1). Credit spreads across most fixed income sectors widened, significantly in some cases, amid concerns that tighter financial conditions created by less accommodative monetary policy could tip the global economy into recession. High-quality bonds that have traditionally offered investors a measure of protection in challenging market environments instead posted some of last year’s most disappointing total returns.

Figure 1

However, this year is shaping up to be a decidedly different story. We believe last year’s interest-rate moves and asset-price declines have spawned a potentially compelling investment opportunity set for risk-conscious fixed income market participants. The early 2023 market rally notwithstanding, we expect multiple good price entry points (along with some volatility) to show up over the rest of the year.

Now is not the time to give up on fixed income

Rising stock/bond correlations in 2021 and 2022 seemingly left no place for investors to hide from market volatility. So, are frustrated investors to conclude that fixed income has lost some of its proven ability to defend principal and diversify other portfolio risks? We don’t think so. Despite fixed income’s prolonged slump through 2022, we remain confident in the power of this cornerstone asset class to retain its key role as a portfolio diversifier and equity downside mitigator in risk-off market environments.

Clearly, that was not so last year — a striking anomaly, in our view. Fixed income exposure in the form of interest-rate duration typically acts as a counterweight to other risks in investor portfolios. For example, periods of risk aversion that tend to negatively impact risk assets such as equities have historically often seen bond prices rise. In 2022, however, aggressive global central bank monetary policy tightening pushed yields up across the yield curve in most developed markets.² The result: Bond prices fell along with equity values, with yields across many high-grade fixed income sectors reaching their highest levels since the early stages of the 2008 – 2009 global financial crisis (Figure 2).

But it’s important to remember that fixed income investors may stand to benefit from prevailing higher yields over multiyear time horizons. While the recent sharp increase in bond yields has been painful for many investors in the short term, we believe it can ultimately serve to enhance fixed income’s longer-term income generation and total-return prospects. Today’s loftier yields may also offer investors better entry points into some fixed income assets, along with a potential cushion against further interest-rate volatility in the months ahead.

Figure 2

Favor high-grade fixed income amid recession risks

We believe high-grade fixed income in particular features an appealing risk/reward profile these days: “All-in” yields were recently perched at relatively attractive thresholds, including credit spreads wider than their long-term historical medians (Figure 3), and high-grade bonds have a lower probability of permanent credit impairment than their lower-quality counterparts. In addition, high-grade fixed income typically performs well in difficult economic settings — worth noting with the threat of a global recession looming over the investment landscape this year. For more on the macro environment, see 2023 Macro and rates outlook: Goodbye easy money, hello regime change by our colleague, Macro Strategist John Butler.

Looking more broadly across credit markets, forward-looking returns appear promising in some sectors, with the core tenets of fixed income/credit (yield, pull-to-par, etc.) potentially working to investors’ advantage given where interest rates and credit spreads currently sit. However, the path of future returns could be quite volatile, with bouts of spread widening likely. As such, we recommend that investors judiciously allocate to credit assets based on their individual risk appetites and other circumstances. For more on credit market opportunities, see Credit market outlook: Partly sunny with a chance of good value by our colleague, Fixed Income Portfolio Manager Rob Burn.

Figure 3

But wait… What about fixed-rate deposits?

The recent inversion of many global sovereign yield curves, together with higher bond yields at the very front ends, may have tempted some investors to allocate to fixed-rate deposits to capture higher yields and limit duration and credit risks. While this approach has its merits, we would caution that fixed deposits entail taking on reinvestment risk — relative to the opportunity to effectively lock in more lucrative yields for at least the ensuing several years. The increasing likelihood of a global recession in 2023 could also supply a catalyst for less restrictive monetary policies and lower longer-term bond yields under a “flight-to-quality” scenario.

To be sure, given today’s structurally higher inflation backdrop, we believe global central bankers will be somewhat hamstrung from cutting their policy rates to levels reminiscent of the post-GFC/pre-COVID years. That said, recent inflation data across a number of developed economies suggests that inflation may have peaked, which would enable central banks to pause or slow the pace of their rate-hiking cycles. Market pricing of policy rates has shifted in recent months, but most are expected to remain elevated, with some chance of rates cuts later in 2023 (Figure 4).

Bottom line: Investors should be aware of the implicit reinvestment risks they would be assuming with an allocation to fixed-rate deposits versus investing in fixed income assets instead.

Figure 4

Portfolio implementation ideas to consider

We expect continued volatility in both the interest-rate and credit markets, with potential for meaningfully greater dispersions among:

• Countries/regions — Global governments may make very different decisions, depending on many factors, not least of which will be where the country is in its economic and electoral cycles.
  
• Credit sectors — Amid continued uncertainty and volatility, some credit sectors could sell off to varying degrees, presenting opportunities for investors to rotate across the global fixed income spectrum.
  
• Individual issuers — Companies that can swiftly identify and adjust to change, control their costs, and wield pricing power should be well positioned to outperform those that cannot.
  

Against this global backdrop, there are a few different types of fixed income strategies that we believe can help meet a range of investor needs and objectives in 2023 (Figure 5).

Figure 5

• Risk-mitigating and diversifying strategies — Many investors allocate to high-quality fixed income through a core bond strategy that includes government and high-rated corporate bonds. For added portfolio diversification, we believe many could also benefit from having allocations to flexible, nimble approaches that aim to capitalize on country-specific characteristics and elevated market volatility (including strategies that seek positive absolute returns, regardless of market direction).
• Core-plus/total return in beta recovery — A somewhat more risk-tolerant investor, and/or one looking to derisk from equities, may opt for a “core-plus” bond strategy that invests in higher-risk assets such as emerging markets debt and high-yield debt. Others may prefer a more dynamic rotational approach, complementing their core allocations with strategies that target fixed income sectors with higher yields and/or potentially more attractive relative value.
  
• Credit-like returns uncorrelated to the broader market — Yet a third option might be to pair a core bond portfolio with a credit strategy that seeks to deliver consistent excess returns (over its benchmark) across a variety of market environments, with low correlation to traditional fixed income market betas.
  

¹Based on calendar-year total returns for both the Bloomberg US Aggregate Bond and Global Aggregate USD Hedged indices. | ²Stock/bond correlations tend to be positive based on a central bank-/inflation-driven catalyst and negative based on an aggregate demand-driven catalyst. Much of 2022 was characterized by Fed-/inflation-driven catalysts, resulting in more positive stock/ bond correlations that dampened fixed income’s typical diversification benefits.

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