Fixed income

Is the worst of the fixed income storm over?

13 June 2022

By Michel Vernier, CFA, London UK, Head of Fixed Income Strategy

  • As the US Federal Reserve and other central banks have started to hike rates amid excessive inflation, losses in bond markets have extended – not helped by higher spreads
  • US inflation is expected to moderate towards the end of the year and might allow the Fed to slow the pace of rate hikes. Until then, rate volatility is likely to stay – especially as interest rates could push beyond 3% in a bid to tame inflation
  • Quantitative tightening by central banks and weaker global growth are rarely good signs for credit investors. In particular, higher-beta names may be prone to more spread widening at this stage of the cycle, which is why higher-quality corporate debt should outperform
  • Within high yield, BB-rated bonds from less cyclical sectors seem preferable, while financial subordinated debt also offers value. More widely, uncertainty is likely to persist, causing further rate and spread volatility. That said, opportunities to add to duration and, selectively, higher spreads should emerge

Losses within the bond market have intensified this year. However, the second half could provide opportunities on rates, along with in credit. Until then, a defensive portfolio positioning seems justified.

Rates and spreads volatility to remain

It’s been another challenging year for bonds with most segments of the market having produced negative returns, so far. Higher rates in anticipation of aggressive rate hikes, especially by the US Federal Reserve (Fed), have been the main driver for the losses. Adding to investors’ woes, spreads, which usually perform well in periods of rising rates, have widened and could continue to do so over the rest of the year.

While the traditional negative correlation between rates and spreads seems to have been somewhat restored of late, we believe that the period of higher spreads and volatile rates is not over yet.

In this environment, some imagination is needed to find pockets of value in the bond market.

Central bank policy drives bond markets

We pointed out in November’s Outlook 2022 that central bank policy will be one of the main drivers for bond market performance this year. At least the anticipated upcoming rate moves have been well signalled by the Fed, which has hinted at 50 basis point (bp) hikes in June and July, and 25bp in the remaining meetings this year. This should lead to a 2.75% upper target fed rate by the end of the year. Meanwhile, forward money market rates imply a peak at around 3.4% by September 2023, before trending towards a neutral rate of around 2.5%.

We have outlined before that the Fed seems to have split the rate-rising exercise into two halves: deal with inflation now, and adjust the rate path afterwards depending on incoming data. As long as this remains the case, the probability of seeing a policy rate above 3% next year shouldn’t be discounted.

A slowing in inflation seems on the horizon

The market has already pared back rate-hike expectations in recognition of a spike in volatility for riskier assets and heightened growth uncertainties. This has led to the most restrictive level of financial conditions for 10 years (excluding during the early phase of the COVID-19 pandemic), according to the Chicago financial conditions index (see chart).  That said, the Fed reminded investors in May that it will raise rates until there is “clear and convincing” evidence that inflation is in retreat.  

The latest US inflation data show signs of slowing price rises in areas of the market that have been particularly impacted by the pandemic, such as the cost of used cars. This, together with base effects, could cause inflation to moderate towards the end of this year.

But inflation uncertainty remains, for now

The Fed forecasts that its preferred inflation measure, core personal consumption expenditure, will drop to 2.1% by the end of next year from 5.2% in March1. This looks ambitious. It would not be the first time that inflation proves stickier than initially expected.

While the market and the Fed continues to debate where the neutral rate for US interest rates lies, we believe that this discussion seems premature, given the above. Looking at the 5-year, 5-year forward OIS swap, it appears that the market is adjusting its expectation upwards, from just over 2% in March to over 2.6% now.

Until we reach the “neutral haven” (if ever), we believe that the risk of higher rates remains to the upside, at least temporarily.

The great unwind and the term premium

Apart from longer-term inflation expectations, which have moderated since April, we believe that term premium will drive longer-end rates in coming months.

Term premium, as measured by Adrian Crump & Moench, stands at -0.2%, compared to -1.11% in June 20202. Recent growth concerns and safe-haven investment flows following the start of the war in Ukraine have slowed the rise of the term premium. However, supply uncertainty, due to the reduction in the Fed’s balance sheet, could add to the upward pressure.

The US central bank has laid out the forecast for shrinking its balance sheet, and will start to let fixed income securities mature, capped at $47.5 billion, in June. This cap will then increase to $95 billion in September3. While the endpoint has not been confirmed, given the pace of reduction, the balance sheet could deflate by $500 billion this year and $3 trillion by end of 2025.

Lock-in opportunities ahead

Given this backdrop, rates have the potential to climb towards 3.5% should the moderation in inflation take longer than anticipated, and with central bank bond sales coming into effect. However, we also believe that inflation will moderate over the rest of the year and that the recent rise in rates implies some for the balance sheet unwind. This, together with subdued growth, should limit excessive rate rises in the long term, increasing the appeal of adding to duration and locking in higher rates at the longer end, should (10-year) rates spike over 3%.

Different playbook for UK and EU rates

By comparison, UK and EU rates may be capped due to the limited capacity of the domestic economies to absorb higher financing costs. While the Bank of England (BoE) started the rate-hiking cycle before the Fed and the European Central Bank (ECB), the path may not be as aggressive.

BoE governor Andrew Bailey was brutally honest in May, acknowledging that record-high inflation will take its toll, especially on the consumer. The central bank is likely to raise rates towards 1.5% as a minimum this year, but may hesitate to hike into the next recession. The bond market will be torn between inflation and stagnation risks, leaving room for a wider range outcome for UK rates. By the end of the year, should growth risks translate into lower inflation, rates could decline again.

Eurozone growth seems equally challenged, but more from manufacturing being hit by worsening supply bottlenecks. That said, the ECB president, Christine Lagarde, has already prepared the market for rate hikes that are likely to start in July and continue until the end of the year.

While the market is priced for more hikes, the central bank needs to keep an eye on financial conditions. Tighter financial conditions could be a problem, especially for Italy, for example.

Given the market is priced for several rate hikes, which has pushed the front-end of the curve well into positive territory, there seems to be an opportunity to lock in short-term positive yields.

Headwind for credit markets

Following rises in interest rates and wider spreads, yields appear more appealing in credit markets. But the risk for further spread widening, especially for higher beta issuers, remains high. Indeed, even after the move, most credit segments still trade close to their long-term average. Given the stage of the cycle and margin pressures facing cyclical issuers, this average pricing does not seem to be justified. Aggressive hikes, an unwinding of central bank bond purchases, and a weakening economy do not usually bode well for credit.

As we highlighted in our April Market Perspectives, spreads tend to widen at the end of a yield curve flattening cycle. As for the magnitude, US investment grade spreads are usually pushed towards 180bp during global recessions (in the absence of a crisis). While we don’t see such an extreme scenario, it wouldn’t be surprising to see wider spreads still, especially for higher beta issuers. This is why we think higher-quality bonds should perform better than those regarded as riskier alternatives.

Focus on bond maturity and credit quality

In this context, shorter-dated investment grade bonds should provide the most stable returns, relative to high yield, emerging markets, or longer-duration bonds. We also take more comfort in the higher entry yields. The average investment grade yield for US bonds is 4.3%, according to the Bloomberg index. Apart from the pandemic peak (driven by spreads) and in 2018 (Fed U-turn), these yields were only achieved in 2010 (in the aftermath of the global financial crisis).

Despite the headwinds, especially for investment grade issuers, balance sheets remain healthy. Net debt to earnings before interest and amortisation, or Ebitda, has declined from 2020’s peak, and interest coverage is still at high levels. In addition, established issuers have been able to extend their term funding during the depressed rate environment and cash levels are higher still.

BBB and financials in focus

These elements are evident in the increased credit supply observed year-to-date. While a defensive approach favouring non-cyclicals and financials appears preferable, in the absence of any sudden major stress, BBB-rated bonds are likely to deliver higher excess returns than A-rated bonds, in our opinion. Indeed, BBB issuers should maintain a more prudent balance sheet strategy, so as to avoid a downgrade while M&A risk could lead to higher supply risk within the A-rated bond segment.

European high yield with more risk

In Europe, margin pressures from higher input costs and lower growth, could get worse and so bargain hunting looks premature. However, investment grade bond spreads are becoming more appealing.

Interestingly, the ratio between European high yield and investment grade spreads is at historical lows (see chart). Yet, unlike high yield, European investment grade bond spreads are at a 10-year high of 160bp (ignoring the early stages of the pandemic). Spreads for both segments have more potential to widen but this risk is significantly greater in high yield, in our opinion. As such, better entry points may arise later in the year.

UK corporate bonds face liquidity challenges

Apart from the economic troubles, liquidity, or the lack of it, appears to be the biggest risk for UK corporate bonds. The BoE is to unwind its corporate bond holding of £20 billion, likely starting in September. Given the small size of the domestic corporate bond market, additional supply constraints could place additional upward pressure on spreads.

Not ready for high yield yet

The average yield for US junk bonds, according to Bloomberg, stands at over 7.8%, a level last seen in June 2020. But an average spread of around 450bp does not seem appropriate in the current environment and given a combination of leverage risk and operational risk.

With higher yields, lower demand, and margin pressure on the horizon, we see upside risk to spreads. And while default rates have fallen to 2% for global speculative issuers, the rating agency Moody’s expects rates to hit 2.7% by December and 3% by next April.

Meanwhile, the ratio of American and European distressed debt is still low in an historical context, even if it has risen of late. This is likely to increase, pressuring spreads more. Levels of 550bp or more, leading to yields of close to 9%, would offer much more attractive entry points.

Favour BB-rated bonds

For now, we favour BB-rated bonds from less cyclical sectors in high yield or financial subordinated bonds. The ratio of potential fallen angels (investment grade issuers downgraded to high yield status) to potential rising stars (high yield issuers upgraded to investment grade status) is still falling, while the rate for rising stars is likely to climb to 11.9%, according to Moody’s. This should provide a positive backdrop for this segment.

In summary, with the environment likely to remain tough for bond investors, a defensive portfolio positioning appears justified for the time being. That said, spread and yield opportunities will likely materialise in the second half of this year.

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