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Since the end of 2021, markets have transitioned from a long-established environment of low volatility and easy trading conditions to a world with much higher volatility and wider bid/ask spreads. Despite the lower market liquidity, this new market regime may offer significantly more opportunities for longer-term global credit strategies to capture the increasing instances of mispricing and idiosyncratic spread widening at both the security and sector level. In our view, strategies that can combine top-down insights with robust bottom-up security- and sector-selection processes are best positioned to look through short- and mid-term volatility and lock in attractive names until maturity at today’s favourable levels.
Since the global financial crisis (GFC), credit markets have become increasingly fragile. While the credit universe has grown exponentially, broker-dealers have been less able to facilitate a consistently liquid market environment. Between January 2008 and May 2022, for example, the US credit market grew from approximately US$2,880 billion to US$9,580 billion whereas US dealer inventories remained low, gradually decreasing from approximately US$70 billion to below US$10 billion.1 The decline in dealer inventories post-GFC is primarily a result of regulatory reforms put in place to prevent a similar crisis from reoccurring. These new regulations, coupled with shattered confidence in the financial system, have meant that sell-side institutions have been less willing to make markets and keep securities on their books.
In the past, the imbalance between the size of the credit market and dealer inventories has not been an issue because central banks stepped in to limit the economic damage resulting from the GFC and, more recently, the COVID pandemic. This has been achieved via massive monetary support in the form of quantitative easing (QE) and zero or negative interest rates creating a “search for yield” environment (Figure 1). Most of this central bank liquidity and support was then recycled back into asset markets, resulting in an environment of increasingly lower yields, compressed spreads and volatility against a backdrop of low to ultra-low inflation and interest rates.
In contrast, we are now looking at an environment in which global central bank liquidity is slowing sharply. In fact, this past June was the first month since 2019 that central banks were shrinking their balance sheets, in stark contrast to only six months ago, when they were collectively buying approximately US$300 billion worth of assets a month. This turning point — as well as the ending of QE in Europe — is becoming a significant headwind for global credit markets, reducing liquidity and generating more volatility and dispersion at both the security and sector levels. In our view, these factors are beginning to expose market fragilities and key structural breaking points that can be exploited by global credit managers.
Since the pandemic, economies’ supply capacity has become much less flexible and slower to adjust to demand. Essentially, the output-gap concept, an economic measure of the difference between the actual output of an economy and its potential output, has once again become relevant, leading to higher and more volatile inflation. The Russia/Ukraine conflict has accelerated and amplified this shift, given the increased risk of energy shortages and supply-chain bottlenecks. These disruptions, coupled with renewed lockdowns in China, have made the growth versus inflation challenge even more difficult for central banks to manage. There is now a clear trade-off between achieving domestic growth and managing domestic inflation, unlike the environment for much of the past 20 to 30 years.
This unenviable scenario for policymakers is highlighted by soaring inflation numbers in developed markets (Figure 2). Central bankers in the US, EU, UK and elsewhere, keen to restore their inflation credibility, have tightened into the downturn and, in doing so, have increased the volatility of the cycle.
In addition to divergent views on the growth/inflation trade-off, other factors — including geopolitical and health-policy considerations — will continue to influence rate-hiking cycles in different regions, meaning country-specific trajectories will become more important again as central banks keep their inflation targets but allow for greater deviations. The countries that are most unwilling to accept weaker growth will generate the highest level of structural inflation and should therefore have the most risk premia priced in. Figure 3 highlights the disparity in short-term interest-rate forecasts, which are constantly evolving in this highly volatile environment.
Moreover, with inflation rising for both cyclical and structural reasons, monetary policymakers are having to shift their reaction function and move away from their implicit contract with investors to preemptively support risk markets. As such, central banks will no longer be suppressors of volatility but volatility generators driving real market cycles. This will create more volatility going into and out of market cycles, increasing the opportunity set for long-term investors who can look through short-term volatility and provide liquidity when the market most needs it.
The magnitude of the recent market moves has no doubt been painful for many fixed income investors but becoming a net seller at this point would merely crystallise losses when, in our view, it is likely that over time these losses will be reduced as markets recover. Moreover, carry should mitigate some of those losses going forward.
In the meantime, we view entry levels across the fixed income sector as now becoming attractive, from both a yield-to-worst (YTW) and an option-adjusted-spread perspective. This is not new — entry points from a YTW perspective have been high for the past few months, but as one of the better longer-term predictors of return, it is worth highlighting. Spreads across Europe, the US and the UK are also now above their long-term averages. European credit has experienced the most significant spread widening out of this complex, with corporate spreads now over 100 basis points (bps) higher than they were at the start of 2022, while US and UK spreads have widened around 60 bps over the same period.
However, yields and spreads will not rise indefinitely; at some point, there will be a natural settling because the economy won’t be able to withstand higher rates without falling into a major recession. Given recent market developments, including the inversion of the US yield curve, we believe that there is a substantially higher risk of a recession next year, and that most economies will slow further during the remainder of 2022. Against this backdrop, we believe now is an appropriate time to start locking in the elevated yields and spreads that we are seeing, especially in Europe, where the moves have been the largest.
Looking ahead, we believe global credit markets will experience more dislocations due to a reduction in liquidity as we move from an environment of “too big to fail” to one of “too big to trade.” We also expect more volatility within global markets, both when moving into and out of cycles. In our view, this combination of lower liquidity and higher volatility will increase the opportunity set for longer-term global credit investors with solid top-down and bottom-up security- and sector-selection processes. Investors willing to look through the short- to mid-term volatility to invest at today’s elevated yield and spread levels can potentially benefit from increased idiosyncratic dislocations via security selection, increased market cyclicality via sector allocation and the solid total returns we expect from fixed income markets over the next several years.
1 Sources: BofA research; Bloomberg. The US market size is the sum of the ICE BofA US Corporate Index’s and the ICE BofA US High Yield Index’s face value.