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Today’s fixed income allocators face a variety of challenges: still-low interest rates, tight credit spreads, increased market fragility, and ever-present liquidity concerns. Growing investor liabilities and spending needs demand reliable fixed income diversification and a more consistent portfolio return profile.
We believe an outcome-oriented, ”all-weather” credit (AWC) approach that encompasses public, private, and perhaps alternative credit investments may help allocators meet these challenges and navigate a wide range of economic and market environments, including unexpected cycles and bouts of volatility. In our view, such an approach to credit investing can enable investors to potentially earn attractive total returns during periods of tight spreads, while remaining positioned to take advantage of market dislocations, exogenous shocks, and shifts in the credit cycle — in short, a durable credit portfolio that is robust and resilient enough to “weather” the inevitable ups and downs of credit investing.
How to design and construct such a portfolio? By using the building blocks of diversified public credit, private credit, and (if appropriate) alternative credit, we believe asset owners can most effectively capture the greatest risk premia in the most predictable fashion throughout the different stages of the credit cycle. This is important because credit investing, by definition, seeks to achieve total returns by harnessing risk and (at times) liquidity premia — spreads and returns that are higher, ideally meaningfully higher, than realized losses. These premia1 are dynamic by nature, moving through various credit sectors and frequently changing in scope and scale over time (Figure 1).
At a high level, we suggest that allocators adhere to the following guiding principles when setting out to build an AWC portfolio:
1. Identify your credit allocation’s goals:
First and foremost, we believe it’s critical at the outset to clearly and realistically define your credit allocation’s long-term goals and objectives, including total return expectations, investment risk parameters, ongoing liquidity needs, and target correlations with other asset classes.
2. Utilize all of the tools at your disposal:
We believe in drawing on a broad investment opportunity set and looking closely at a portfolio’s combined credit exposures. That means striking a balance across private credit markets and diversified public credits, as well as allocating to credit strategies with differing betas and liquidity terms in pursuit of the hoped-for risk-adjusted return outcome.
3. Be holistic, not siloed, in your approach:
Be prepared to view your credit allocation holistically, from a total risk and return perspective, versus a siloed approach that splits the allocation among multiple distinct credit “buckets.” Strategy diversification makes the whole greater than the sum of its parts and boosts the likelihood of achieving strong risk-adjusted returns across business cycles.2
Any discussion of building an AWC portfolio must consider the proper framework within which such a strategy should be constructed, with an eye toward maximizing the potential benefits of each of its component pieces. For a deeper dive, please download the full white paper from which this excerpt was taken, A credit strategy designed for all seasons.
1A risk premium is the investment return an asset is expected to generate in excess of the risk-free rate of return, as typically represented by US Treasury bills. | 2Diversification does not ensure a profit or guarantee against loss.
As we enter the stretch run of 2021, there are two key takeaways from our latest bond market outlook. We believe fixed income investors should think about: 1) paring back some risk exposures as 2022 takes shape; and 2) turning to select nontraditional sectors for higher total return potential.
As of this writing, we maintain a neutral risk posture overall, having grown wary of some fixed income exposures in recent weeks, particularly certain higher-yielding credit sectors. On a more upbeat note, we still believe some spread sectors can benefit from continued above-trend global growth, underpinned by healing labor markets and an improving public health backdrop.
We suspect global inflation may prove more enduring than the US Federal Reserve (Fed) and broad markets expect, even as some supply bottlenecks ease, thereby testing the Fed’s patient resolve in removing policy accommodation. Despite the planned tapering of Fed asset purchases in the months ahead, monetary policy should continue to provide an economic tailwind, likely to be augmented by additional fiscal stimulus measures (including the US infrastructure bill).
On market valuations, recent rich levels in many credit sectors could leave investors vulnerable to negative returns if markets encounter unanticipated tail risks. However, as we look across the fixed income spectrum, we still see pockets of attractive value for investors to consider, notably in some nontraditional credit sectors. Accordingly, 2022 may be a year in which bond investors need to “break with tradition” in the search for higher return potential.
With valuations generally being so elevated, what has kept our credit risk outlook neutral and not poor? The short answer is, ”everything else.” Our other quantitative indicators are mostly quite positive at this time: Corporate behavior generally remains conservative, global central banks supportive (despite steps toward monetary policy tightening), and market technicals strong, all of which keep us from advocating for more cautious portfolio positioning — yet anyway.
Of the indicators cited above, monetary policy (including a rising-rate outlook) appears to be the one that is closest to begin flashing a “warning signal” and thus bears close scrutiny going forward (Figure 1). In particular, the prospect of higher-than-expected, longer-lasting structural inflation suggests that major central banks may feel the need to start tightening policy sooner rather than later. A potential policy mistake in the form of tightening too soon or too quickly could prompt us to adopt a more defensive risk stance in 2022.
Another potentially potent tailwind for markets, which isn’t captured in our quantitative analysis: unprecedented amounts of fiscal stimulus. The combination of ample fiscal and monetary support has given us conviction that the global economic expansion should continue in 2022.
So with regard to fixed income risk management, why do we think investors should consider reducing risk now? Again, it comes down to rich, arguably stretched valuations. Our credit research framework tells us that it may be an opportune time to lower risk exposure, but gradually, when spreads reach levels like today’s.
One way of looking at credit valuations is relative to government bonds. For example, we like to examine the “breakeven” default rates for various high-yield bond indices. Figure 2 shows the cumulative expected default rates required over the next five years for each high-yield index to merely keep pace with US government bonds (blue bars), as compared with “worst-ever” (red) and average (yellow) historical default experiences. (The breakeven calculation is that spread earned equals default losses.)
As shown in the far-left bars, a 21% default rate would wipe out the spread earned in US high yield, versus an average realized default rate of 22%. This means that if we see an average default rate over the next five years, a risk-averse investor would be better off holding US Treasuries. In order for investors to earn a risk premium in high yield, defaults would need to register well below average. Translation: High yield appears priced for a very rosy, likely unrealistic outcome. While near-term default forecasts are indeed benign, we have less confidence in the market’s ability to predict several years out. Bank loans, conversely, look better positioned to withstand default losses. As such, we generally prefer bank loans over high yield these days.
A few credit sectors stand out to us as having a higher probability of generating excess returns in 2022 (Figure 3):
Reductions in fixed income portfolio risk may be warranted in the months ahead, especially if valuations remain tight or compress further. However, we also think investors should remain nimble if, for example, bouts of increased volatility lead to greater idiosyncratic dispersions or inefficiencies across fixed income markets. In this still-uncertain environment, a “barbelled” approach, consisting of larger allocations to higher-quality, liquid assets like cash and developed market government bonds, may make sense. For greater return potential, where appropriate, leaning further into those select, non-traditional sectors highlighted above may be an effective strategy in 2022.
As we enter the stretch run of 2021, we are witnessing a seismic and rather abrupt shift in the global monetary policy framework. Notably, the big developed market (DM) central banks are gradually moving away from traditional forward guidance toward emphasizing greater policy flexibility and better risk management in response to economic and market developments. Based on recent central bank decisions, we think market participants will be less inclined to see monetary policymakers as reliable forecasters or drivers of economies and business cycles.
DM central banks, especially the US Federal Reserve (Fed), now find themselves in the unenviable position of grappling with stubborn supply-side inflation and fundamentally transformed job markets. Low unemployment rates, which are virtually back to pre-pandemic levels in major economies, may signal that the active labor pool has been structurally diminished by some combination of early retirements, reduced immigration, labor support schemes, and/or people leaving the workforce altogether during COVID-19. Global policymakers are still trying to determine how many jobs are just “missing” and likely to return eventually, versus how many are probably never coming back (Figure 1).
One medium-term implication of this shifting monetary policy backdrop is that global central banks seem to be losing tools and ammunition from their conventional policy tool kits.
For example, forward guidance and rhetoric, along with yield curve control (YCC) measures, are increasingly perceived as less effective and less credible than in the past and will therefore likely play a smaller role in central banks’ approach to navigating future economic cycles. Similarly, most central banks now recognize that quantitative easing (QE) can help combat bouts of market turmoil, but is not a suitable means of generating sustainable inflation in line with policy targets. Consequently, the risk central banks now face is that if they prematurely tighten monetary policy, they will have even fewer tools at their disposal to adapt to fluid economic and market conditions.
In general, we still think the potential costs of policymakers being “early and wrong” in their actions are greater than being “late and wrong.” In addition, today’s market dynamics have resurfaced the age-old question of whether monetary policy tightening is even the best way to manage higher inflation driven by supply shortages. And could rising prices themselves lay the groundwork for a weaker cycle by blunting consumer demand for goods and services?
Global markets and policymakers alike are coalescing around the view that global inflation will likely remain elevated for the foreseeable future (“persistent,” not “transient” as previously hoped). However, the major DM central banks’ policy responses thus far have varied somewhat:
As of this writing, our baseline “taper path” for the US Fed is that it will likely complete the winding down of its asset purchase program by around June 2022. The Fed has retained the option of adopting a faster pace of tapering if warranted, any further indication of which in the months ahead would validate the market’s latest forward-pricing expectations. (Currently, markets expect Fed rate hikes to begin next summer, followed by the next rate increase in November). The Fed has indicated its preference for a time gap between the end of tapering and its first rate hike, but again, flexibility is the watchword here. Should the recent acceleration in wage pressures prove to be “sticky,” for example, the Fed might have to change course.
At this juncture, we anticipate a modestly dovish outcome for the BOE’s policy trajectory. The BOE surprised markets recently by choosing not to raise interest rates, citing job market uncertainty and other factors. It also acknowledged that its ability to loosen policy in response to any future negative demand shocks will be hemmed in by the lower bound on rates, implying a “go gradual” approach to normalization.
Despite the fate of the RBA’s YCC target (see above), we think the market’s hawkish policy expectations, now priced into the front end of Australia’s yield curve, are slightly overdone. We maintain a favorable bias toward select Asia-Pacific duration markets, including Australia’s.
Front-end yield curve markets have been testing global central banks’ patience and resolve. Longer-dated sovereigns have reacted via curve flattening, suggesting a greater chance of a policy error (e.g., tightening policy too early). This has been particularly evident in the UK and US fixed income markets. Much of the recent change in front-end pricing appears to have brought the timing of rate hikes forward as opposed to extending hiking cycles. Hence, we think fiscal policy will begin to replace monetary policy as the main influence on market direction.
If the US human and physical infrastructure bills pass, markets can then put a higher probability on increased government investment in the coming years. This would be a potent catalyst to (at least in the short term) break the substantial US yield curve flattening trend of recent months. Meanwhile, the European and UK fiscal pictures both point to the likelihood of high (and potentially rising) spending outlays in the period ahead — in contrast to the US, which could be in stalemate over additional government spending post the 2022 midterm elections.
Globally, growing appetites for climate-related investment needs and increased sociopolitical preferences for higher budget deficits suggest a more activist fiscal stance relative to monetary policy over the next few years.
Emerging markets (EM) central banks have taken a markedly different policy approach from that of their DM counterparts, “front-loading” rate hikes in an effort to counter inflationary pressures. This hiking cycle has been driven by a need to anchor inflation expectations and to avoid currency depreciation and related instability, which have been a headwind for many local rates but have also created pockets of value in select EM assets. We continue to believe Chinese local rates are attractive, given their potential diversification benefit from historically low correlations to other sovereign debt markets. Moreover, China’s economic and policy cycle is in a different phase than other EMs, with output now slowing and the People’ Bank of China (PBOC) likely to pursue easier monetary policy, with an eye toward loosening financial conditions, going forward.
On China’s economy, we think further growth downside is limited, provided the PBOC’s overall policy tone remains accommodative. The two obvious wildcards that could jeopardize this usual two-step of “policy looser, growth stronger” would be a structural deterioration of home-buyer sentiment and a further acceleration in inflation. However, the apparent lack of transmission from sluggish real activity in China to softer commodity pricing is a distinguishing feature of this current cycle, as is the absence of feedthrough to growth in the rest of the Asia-Pacific region.
Global inflation dynamics are undeniably changing, and most likely not for the better. At last check, inflation was already registering above its pre-pandemic peak (Figure 2), despite lower levels of economic growth, in both EMs and DMs. This is partly due to temporary phenomena — chiefly the so-called “bottlenecks” associated with COVID-induced supply-chain disruptions — but it also seems to reflect a structural shift to persistently higher rates of global inflation henceforth. What’s driving it? A number of the key factors that dampened inflation over the past 30 years are now in reverse and have largely given way to other global forces with more long-term inflationary effects: deglobalization, localization of supply chains, labor shortages triggered by COVID, and evolving consumer preferences and habits, among others.
The next six months could be characterized by rocky, uneven growth patches. Nevertheless, at a high level, we still think the most likely endgame for the global cycle that is now underway should be one of reflation rather than the much-feared “stagflation” scenario, as many consumers spend down the savings they accumulated during the pandemic, corporations increase capital expenditures (capex), and government policy — particularly fiscal — remains supportive. We believe the greater risk is that of recession rather than stagflation if, for example, inflation squeezed real wages and turned the cycle over, global COVID cases resurged, central bankers prematurely tightened policy, and/or China’s slowdown worsened.
In any event, what is clear is that rising global inflation is leading central bankers worldwide to reassess the risk/reward trade-off of letting their economies “run hot” or for too long. Accordingly, investors should no longer assume that flagging economic growth will always result in ever-more policy-driven liquidity courtesy of central banks. With that in mind, a pivotal (and as-yet unanswered) macro question is whether labor market dynamics have changed sufficiently to allow workers to be compensated for higher inflation through higher wages. If so, then inflation is likely to have legs and monetary policy to tighten sooner and by more than markets expect. If not, then the cycle would likely sour, as consumers’ purchasing power gets increasingly pinched.
In the US, our current bias is toward higher unit labor costs and more enduring inflation relative to the Fed’s and market’s expectations. Pipeline cost pressures, supply bottlenecks, and retail price intentions would suggest that goods inflation stays elevated, before waning over the next 12 months. At the same time, we think core services inflation, which is more sensitive to the domestic output gap and labor markets, will start to pick up. If our leads are right, all of which imply upside risks to the Fed’s 2022 inflation forecasts, we suspect the Fed would start to more seriously question the dubious “transitory narrative,” especially given some improvement in the labor market. We will be closely monitoring the details of capex and of prospective fiscal policy for anything that might challenge our thinking.
The Fed seems pretty upbeat about US productivity growth rising in the context of potentially higher labor market participation rates. This attitude underpins the Fed’s belief that: 1) longer-term inflation will likely settle back around 2.0% over time; and 2) there remains excess capacity in the domestic labor market. While recent productivity, wage, and inflation data don’t necessarily support that, we think the Fed’s optimism is still justified given today’s labor shortages, US demographics, and other factors. It would likely take time for the Fed to meaningfully revise its view on structural productivity trends.
Commodity prices will be critical to both the global and US inflation outlooks. A potential change in OPEC+’s reaction function (including a marginally greater tolerance for higher oil prices) and/or US shale discipline preventing a proportional increase in US oil production could continue to push oil prices upward in 2022.
Broadly speaking, ongoing decarbonization will likely restrain global growth to some degree, at least until countries can map out viable longer-term energy transition plans, including a “bridge” of sorts (i.e., natural gas) between fossil fuels and renewable energy. In the interim, commodity price pressures are showing signs of impacting the “economic reopening-linked” demand and growth recovery. But the US consumer has rarely been healthier, with the low-wage cohort in particular stepping up its spending in an environment of significant labor shortages and widely understated wage gains. The US economy seems better placed to weather the latest energy “storm” than DM energy importers like Japan, the UK, and the eurozone. In addition, US trade exposure to China looks negligible when compared to that of Australia, New Zealand, and Japan.
The challenges of the past 18 months or so have highlighted the potential for environmental, social, and governance (ESG) factors to become even more relevant to asset management and have underscored the ever-increasing importance of stewardship by fiduciaries and active investors alike. ESG has quickly become one of the defining investment criteria of this decade — a trend we have little doubt will endure in 2022 and beyond.
We have long believed that mounting sovereign debt burdens pose a risk to investors, even in developed markets. At the very least, investors are not being adequately compensated for investing in the most heavily indebted countries. Given the sharp rise in government debt levels in response to the global COVID-19 crisis, it’s an opportune time for sovereign bond investors to refresh their investment frameworks, the particular metrics to be applied, and their country-selection methodologies, including the ESG factors underlying investment decision making.
Our sovereign risk framework (SRF) incorporates ESG factors, which we see as indicators of a country’s structural stability or long-term ability to generate economic growth and meet its debt obligations. (Notably, as discussed below, we recently elevated the already important role of ESG factors in our SRF framework.)
ESG/structural stability remains one of four pillars of the overall framework (Figure 1), with the other three being the country’s: 1) fiscal and monetary flexibility; 2) economic imbalances; and 3) total public debt outstanding. The primary output of the framework is a ranking system, which allows to us exclude from consideration those countries deemed to have the weakest sovereign fundamentals.
While ESG encompasses a wide range of concepts, we worked through a long list of components to identify those metrics that have historically exhibited the strongest correlations with a country’s long-term economic performance.
Overall, we firmly believe that a more complete integration of ESG factors into our sovereign debt investment approach can deliver meaningful benefits to clients in the coming years. With respect to climate risks specifically, given their critical importance to investors and regulators, we will continue to seek new ways to proactively implement the findings of our ongoing research efforts.
This is an excerpt from our 2022 Investment Outlook, in which specialists from across our investment platform share insights on the economic and market forces that we expect to influence portfolios in the year to come.
