Fixed income: Relative value opportunities amid growth slowdown

Rob Burn, CFA, Fixed Income Portfolio Manager
2022-10-31
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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.

Where are we in the credit cycle?

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.

Where are the relative value opportunities?

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

  • European corporate credit spreads have underperformed their US counterparts by the biggest margin since the depths of the eurozone crisis and were recently trading 60 basis points (bps) wide on an issuer-matched basis.
  • Senior AAA rated structured finance assets have come under pressure as a result of technical selling activity (as opposed to fundamental concerns). Residential mortgage sectors, including single-family rentals and nonqualifying mortgages, stand out as particularly attractive to me.

Sub-investment-grade debt

  • European contingent convertible bond (CoCo) spreads have widened significantly of late. While the Russia/Ukraine war has created an energy shortage problem, it has also given European governments cover to support their economies and ensure that their banks remain solvent.
  • Residential mortgage-backed securities (RMBS) and credit risk transfer (CRT) bonds have come under pressure from concerns about potential home price depreciation. However, many underlying homes have already experienced significant price appreciation. And credit enhancement in recent years has made even the lower-rated tranches very “default-loss-remote,” in my view.
  • High-yield credit derivatives (iTraxx crossover) currently trade wider than their issuer-matched cash bonds – an atypical phenomenon, except in recessionary environments. 

“Sell” ideas

  • Emerging markets (EM) sovereign spread widening has not kept pace with other global credit sectors. Spreads now trade around the 40th percentile relative to history, which is very surprising given the potent fundamental headwinds facing many EM countries.
  • CCC rated high-yield bonds appear expensive relative to their higher-rated counterparts, indicating a lack of dispersion across today’s high-yield market. These credits are most vulnerable to default risk in the event of an economic slowdown.
  • Taxable municipal bond spreads, currently trading inside historical median levels, have not yet widened enough to warrant “wading in.” The potential carry return looks too low given their long-spread duration, in my judgment.
  • Convertible bonds have held up surprisingly well amid this year’s equity market sell-off. However, I worry that the equity upside may be limited with corporate earnings likely to be squeezed by potential margin compression. Many converts trade far “out of the money” and offer relatively low coupons to boot.

Final thoughts on fixed income opportunities

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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