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How can bond investors add value in the current environment? We asked Connor Fitzgerald, lead portfolio manager of the Wellington Credit Total Return platform, to share his thoughts on positioning for an uncertain outlook.
I think there is a lot of value in fixed income right now. Rising interest rates have pushed up the yield on the US 10-year Treasury bond through 2023. Meanwhile, although corporate spreads aren’t exactly cheap, they also aren’t expensive relative to historical averages. This combination can make all-in yields compelling. It is possible to achieve yields greater than 6% at present in high-quality fixed income.
Like every other portfolio manager, I too am weighing the likelihood of a soft versus a hard landing, but I tend to think we are in a positive total return environment for bonds regardless. When looking at each of these scenarios, it’s important for bond investors to consider the impact of skew on total return. I think there’s an attractive skew to be found within a hard landing scenario. For example, take an intermediate corporate bond with a four-year duration, yielding around 5.5%. If we were to see a 100 basis points (bps) increase in yield, basic bond maths tells us we can expect a one-year total return of 1.5%. Conversely, a 100 bps decrease in yield results in a 9.5% total return. I put more weight on the latter scenario playing out than the former, and think this skew is underappreciated by the market. If you are at all concerned about the global economy, bonds could make a lot of sense.
In my view, BBB rated, intermediate-duration (two- to ten-year) credit offers compelling yields. I prefer the yields and spread available in this part of the market to longer-dated corporates where 30-year spreads are tight.
Having exposure to corporate bond spreads is attractive, but given the uncertain market outlook, I don’t want to be too far down in quality at this point. For that reason, BB rated high-yield exposure could be a more compelling option than lower-rated bonds.
My view on maturity and duration is somewhat nuanced, given the market backdrop. I believe portfolios could benefit from exposure to falling yields.
In US Treasury bonds, I favour three- and five-year exposures. If we enter a recession, there is scope for yields to rally. As the market prices in a Fed-easing response, I think low-duration Treasuries could outperform longer-dated exposures, resulting in a “bull-steepening” yield curve, where the short end of the curve falls faster than the long end. I also like four- and six-year corporates for the all-in yields available per unit of duration.
There seems to be good value in banks at the moment, especially looking at current spreads relative to history, and I think a soft landing would be positive for their businesses. I also like the energy sector, where I see promising opportunities in both developed and emerging market (EM) energy names.
At the margin, we have been adding to EM corporates more generally; the new-issue market is now reopening with some interesting buying opportunities. EM high-yield corporates, again focused on BB rated names, currently provide attractive spreads compared to their developed market equivalents.
If Fed tightening is still working its way through the system and we ultimately end up with more of a hard landing scenario, we might see more volatility in sub investment-grade exposures, but I’m not convinced that high-yield bond prices would necessarily fall too far. Spreads would likely widen but I’d expect the positive effect from duration to offset this somewhat.
All-in yields are attractive on a historical basis and could provide a compelling anchor from a total return perspective. As Figure 1 shows, looking at various scenarios (rates higher/lower, spreads wider/tighter), investors have an opportunity to earn their yield, with price effects either adding or detracting in terms of holding period-total returns.
Either way, in the event of a hard landing and a widening of high-yield spreads, I expect to be a buyer, focusing on finding names that are less exposed to a downturn. I’ve been adding high-yield exposure recently — lending money to what I believe are good-quality companies at an 8% starting yield represents good value to me.
If we were to see more of a soft landing scenario play out, I would expect to be adding credit exposure, especially BBB and BB rated corporate names. I think employing a flexible total return approach, allocating to credit (investment grade, high yield or emerging market debt) when there is value or seeking safety in US Treasuries and cash when credit valuations appear stretched, has a lot of merit, especially against the uncertain economic outlook we are faced with.
I would view this as a risk case rather than a base case. I am of the view that investors could benefit from positioning for a bull steepening, assuming the Fed will be in a position to ease policy rates at some point, resulting in lower front-end yields. If inflation remains stubbornly high and the Fed has more to do, coupled with the potential reemergence of term premia, especially in the face of ongoing fiscal deficits and resultant heavy Treasury issuance, we could possibly see higher long-end yields, or a bear steepening of the curve.
I come back to my view of an attractive skew in these potential outcomes. While the Fed may have more to do, potentially pushing yields higher, if the economy goes into recession, I think the curve will steepen dramatically and front-end exposures will perform well.
Whether yields go up or down from here, I believe bonds look attractive from a total return perspective. However, remaining flexible is key in an uncertain macroeconomic environment; adding to exposure and tilting towards higher-quality credit could benefit portfolios in a market downturn, while adding to credit risk may add value on the other side of a downturn.
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