- Fixed Income Portfolio Manager
- Funds
- Capabilities
- Sustainability
- Insights
- About Us
- My Account
United Kingdom, Intermediary
Change
The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
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.
Expert
Related insights
Showing
of
Insights Posts
The shrinking central bank balance sheet: A credit market opportunity
Continue reading
Quick Take
2022-11-30
Why today’s fixed income market is fertile ground for active management
Continue reading
Quick Take
2022-12-31
Global convertibles: Unprecedented times call for unconventional solutions
Continue reading
Quick Take
2022-11-30
Credit investing against a slower-growth, higher-inflation backdrop
Continue reading
Quick Take
2022-07-31
Credit and equity risk back on speaking terms, but will it last?
Continue reading
Quick Take
2022-10-31
URL References
Related Insights
Stay up to date with the latest market insights and our point of view.
Read Next
Showing
of
Insights Posts
The shrinking central bank balance sheet: A credit market opportunity
With the shift in central bank policy, heightened volatility and dispersion may yield a promising environment for exploiting credit market inefficiencies.
Continue reading
Quick Take
2022-11-30
Emerging local debt markets: Time to wade in?
Fixed Income Portfolio Manager Michael Henry sees positive trends across ELD fundamentals, valuations, and technicals that could be tailwinds for these markets going forward.
Continue reading
Article
2023-08-31
Why today’s fixed income market is fertile ground for active management
Skilled active management has potential to shine in times of increased dispersion across fixed income sectors and regions. Now may be one of those times.
Continue reading
Quick Take
2022-12-31
Global convertibles: Unprecedented times call for unconventional solutions
Fixed Income Portfolio Manager Michael Barry and Investment Director Raina Dunkelberger argue that global convertible bonds are well suited to today's uncertain market environment.
Continue reading
Quick Take
2022-11-30
Don’t be surprised if CLO equity surprises to the upside
Members of our fixed income team, including Portfolio Manager Alyssa Irving, believe CLO equity could be poised to outperform many other risk assets over the next few years.
Continue reading
Quick Take
2022-10-31
Credit investing against a slower-growth, higher-inflation backdrop
The significant flattening of the US Treasury yield curve in recent months has some prognosticators calling for an impending US recession. Not so fast, says Fixed Income Portfolio Manager Rob Burn.
Continue reading
Quick Take
2022-07-31
Credit and equity risk back on speaking terms, but will it last?
Following their uncharacteristic rift and recent reconciliation, Director of Wellington’s Global Derivatives Group Gordy Lawrence considers whether equity volatility and credits spreads are likely to remain in harmony.
Continue reading
Quick Take
2022-10-31
A transition year for agency MBS?
Following a challenging period for agency MBS, members of our securitized team now see attractive opportunities in the space and believe actively managed strategies may be the best way for many investors to capitalize.
Continue reading
Quick Take
2022-07-31
Sustainable fixed income investing comes of age
ESG integration and sustainable investing have gained considerable traction in global fixed income markets. Investment Directors Anand Dharan and Meredith Joly and Fixed Income Trader Keenan Choy discuss this ongoing trend and some of its key implications for asset allocators.
Continue reading
Article
2023-06-30
Empirical duration: reason for optimism on risk assets?
While rising rates often produce negative bond returns, combining the concept of empirical duration with a positive outlook on the credit cycle may bode well for some fixed income sectors' return prospects going forward. Investment Analyst Will Prenits and Investment Director Tobias Ripka explain.
Continue reading
Quick Take
2022-07-31
Global credit: Where do we go from here?
Fixed Income Portfolio Manager Mahmoud El-Shaer explores why 2022 may be a momentous year for global credit and sets out a framework to think through potential investment implications. 2022 promises to be another challenging year for central banks as they attempt to normalise policies in the face of surging inflation, while navigating the growing fallout from Russia’s invasion of Ukraine. Since 2009, there has essentially been one trade in capital markets: riding a huge wave of central bank liquidity in support of the financial system and the economy, with the G4 central banks alone pumping approximately US$20 trillion into the system via quantitative easing (QE).
Continue reading
Quick Take
2022-07-31
URL References
Related Insights