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Global fixed income markets have experienced an extremely challenging start to 2022. Investors, consumers, and businesses alike have grappled with the strongest inflationary pressures in 40 years, exacerbated by a commodity price shock, geopolitical uncertainty from the Russia/Ukraine conflict, and tighter global financial conditions resulting from the shift to less accommodative central-bank monetary policies.
While this year’s market turmoil has led to negative total returns across most fixed income sectors, I believe it has also created attractive opportunities for investors with longer-term time horizons.
In aggregate, our predictive cycle indicators suggest the global economy may enter a mild recession later this year or next. More restrictive central-bank policies are a headwind that’s unlikely to abate in the near future, intermediate- and long-term interest rates have risen significantly, global demand for goods exceeds supply (the so-called “output gap”), and the effects of high prices on demand and companies’ profit margins are hurting business confidence. However, we do not expect a meaningful increase in corporate defaults in the period ahead given that many of the weaker credits in the market already defaulted during the early stages of the COVID pandemic.
Unlike past credit cycles (e.g., the 2001 tech collapse, the 2007 subprime crisis, the 2015 energy collapse, the 2020 pandemic), I do not see any immediate and tangible link to a large group of companies that look poised to default anytime soon. We may very well get there eventually, but it will likely take more time for the cracks in their corporate armor to emerge. In the meantime, current valuations across many fixed income sectors should provide some downside cushion. For example, high-yield bond spreads imply a cumulative default rate of 36% over five years.1 Compare that to the sector’s long-term average and worst-ever cumulative default rates of 22% and 32%, respectively.
In the wake of this year’s heightened market turmoil and volatility (which has contributed to different fixed income sectors selling off to varying degrees and at different times), I observe a number of opportunities for investors to rotate capital across sectors and shift credit risk to areas with potentially attractive risk/reward trade-off profiles. Here are some of my current favorites across both investment-grade and high-yield fixed income, as well as possible funding sources to consider:
Investment-grade debt
Sub-investment-grade debt
“Sell” ideas
Looking ahead over the balance of 2022 and into 2023, I believe there should be ample relative value opportunities to continue adding credit risk at wider spreads and to seek to take advantage of fixed income market dislocations. However, I also believe it’s important for investors to stay flexible and nimble with their capital. Among other things, that means maintaining a sizable portfolio allocation to cash and liquid developed-market government bonds to be able to capitalize on market opportunities as they arise.
1Breakeven default rate, based on Bloomberg US High Yield Index option-adjusted spread of 469 basis points as of 31 July 2022, assuming 40% historical average recovery rate on defaulted bonds.
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