- Fixed Income Portfolio Manager
Formats
Corporate Sustainability
Investment Solutions
Our approach to sustainability
Netherlands, Intermediary
ChangeThe 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.
This is an excerpt from our 2023 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. This is a chapter in the Bond Market Outlook section.
Like many global fixed income sectors, the high-yield bond market has struggled mightily year to date. For example, the ICE BofA Global High Yield Constrained Index had returned a dismal -16.03% as of September 30, 2022. With any luck, 2023 will be a better year, but high-yield investors may want to exercise a measure of patience and be prepared to capitalize on market dislocations when they arise.
Maintain neutral risk posture, look to exploit market dislocations
Fortunately, I expect there to be no shortage of opportunities for investors to take advantage of high-yield market dislocations in 2023, particularly amid some of the macro risks I am watching — notably, tighter global monetary policies and debt sustainability concerns in Europe as borrowing costs rise. Broadly speaking, I believe a close-to-neutral risk posture may make sense in the coming months, but while maintaining sufficient liquidity to deploy capital at potentially more attractive high-yield valuations.
Big picture: The good, the bad, and the risky
There has been some easing of supply-chain bottlenecks and energy prices in recent months. However, global monetary policies likely will remain restrictive, in aggregate, in an effort to weaken consumer demand and thereby bring down persistently high inflation. Thus, I am closely monitoring the risk of a policy mistake by one or more central banks, as they attempt to toe the line between keeping inflation in check and not tanking their economies. In Europe, any adverse impacts on growth from European Central Bank (ECB) rate hikes should be partially offset by expansionary fiscal policies.
While I expect the macroeconomic backdrop to deteriorate further, I do not anticipate a deep global recession or a full-scale credit default cycle. Rising input costs contribute to weaker corporate fundamentals, but they also lower the cost of debt in real terms over time. Unhedged floating-interest expenses may become a concern for lower-quality companies with large floating-rate liabilities in their capital structures. The new-issue market is reopening for issuers that are willing to pay higher borrowing costs, but given the relative lack of refinancing needs, few have chosen to take advantage so far.
Following the recent high-yield market sell-off, I believe today’s lower dollar price and higher-rate setting may present attractive entry points for longer-term investors. That being said, patience may well be a virtue when it comes to increasing one’s high-yield risk exposure. Tail risks are rising in an environment of evaporating market liquidity, and I suspect that some of the economic and market excesses created by a prolonged period of low rates will become sources of volatility as they are being unwound.
Evaluate opportunities in AT1 bank securities
As of this writing, one of the best risk/reward trade-offs I observe in the global high-yield opportunity set is in the lower part of the capital structure: additional tier 1 (AT1) bank securities, a type of contingent convertible (“Coco”) bond, which offer yields in the range of 8% to 10% (Figure 1). Fundamentally, I believe the sector remains healthy overall. In addition, the risk of coupon deferral and/or principal loss appears remote, in my view, while extension risk — from the banks not exercising their call options — is already largely reflected in the securities’ prices.
As of early October 2022, the sector had been trading poorly for weeks — typical for banks during periods of economic uncertainty, but I expect it to bounce back in the months ahead. However, the current cycle is very different from most past cycles in that sector earnings actually have been rising as opposed to falling (as demonstrated by 92 consecutive weeks of earnings-per-share upgrades). I forecast this to continue given that many banks look well placed to benefit from higher interest rates.
Figure 1
At the same time, I am seeing a very strong fiscal policy impulse that may help protect banks from higher loan losses, as many governments take steps to support vulnerable households and effectively limit loan defaults. The banks also maintain high levels of provisions that were built up during the pandemic and can be repurposed as needed. I expect top-line revenues to eventually slow as loan demand fades after the recent refinancing wave, but higher rates are boosting banks’ profitability, while asset quality remains benign and capitalization adequate, in my judgment.
Final thoughts for investors
Many high-yield market participants remain defensively positioned, recognizing the worsening macroeconomic outlook, with emerging markets and European debt among their largest regional underweights. While I still anticipate some further market volatility and potential downside, the eventual “snapbacks” could occur quickly if macro conditions improve and investors scramble to cover their underweights. Under such a scenario, an ensuing increase in market dispersion could create more investment opportunities for nimble, discerning active investors. Again though, patience in adding high-yield risk may be warranted: Consider awaiting evidence of decelerating inflation that may finally enable global central banks to slow or pivot their policy tightening.
Expert
READ NEXT
Article 1 from Alternative Investment Outlook
Related Insights
Showing
of
Insights Posts
February Fed meeting: Chair Powell strikes a more optimistic tone
The Fed just might still be able to engineer the hoped-for "soft landing" but it's not going to be easy, says Fixed Income Analyst Caroline Casavant.
Quick Take
2023-09-30
Why global investors should watch the Bank of Japan
Macro Strategist John Butler explores why global investors should watch the Bank of Japan and what is likely to happen next.
Quick Take
2024-01-31
Financial Market Review — Fourth quarter 2022
A quarterly update on equity, fixed income, currency, and commodity markets.
Whitepaper
2023-07-15
Monthly Market Snapshot — December 2022
A monthly update on equity, fixed income, currency, and commodity markets.
Whitepaper
2023-03-15
Spread the risk: Our top three fixed income diversifiers for 2023
Fixed Income Strategist Amar Reganti highlights three types of strategies that may be well positioned to provide fixed income portfolio diversification going forward.
Quick Take
2024-01-31
CLOs: Poised to outperform in 2023?
Collateralized loan obligations (CLOs) have been sparking investor interest lately — and with good reason, say Investment Director Andrew Bayerl and Investment Specialist Celene Klimas.
Quick Take
2024-01-31
Can US bank loans “carry” investors through 2023?
Fixed Income Portfolios managers Jeffrey Heuer, CFA and David Marshak and Investment Director Nick Leichtman describe what they see as the most prudent approach to the bank loans asset class in 2023 and why.
Quick Take
2024-01-31
Take credit: Our five best credit market ideas for 2023
Fixed Income Strategist Amar Reganti highlights credit market opportunities that he expects to arise over the course of 2023, against a backdrop of slowing growth.
Quick Take
2024-01-31
US recession risk: No longer if, but when and how bad
Portfolio Managers Brij Khurana, Brian Garvey, and Nick Petrucelli believe many observers are underestimating the severity of a potential US recession this year.
Quick Take
2024-01-31
Picture this: Our 2023 economic forecast in five charts
We explain the shifts the market is undergoing, analyze the implications for different asset classes, and identify potential risks and opportunities in a series of visuals.
2023-12-31
Navigating the new global economy in 2023
This executive summary distills the points of view of several of our 2023 Outlook authors. Discover the risks and opportunities they see as we enter a new economic and market regime.
Article
2023-12-31
URL References
Related Insights