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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.
When I published my 2023 credit market outlook back in October 2022, I advocated for a defensive portfolio risk posture amid growing recession risks, while still preserving sufficient cash/liquidity to take advantage of anticipated market dislocations. Following a rally in many market segments, I’ve observed a shift in credit risk and sector rotation opportunities.
While I still favor defensive positioning from a tactical perspective, in the wake of last year’s sharp rise in yields, I believe higher-yielding credit sectors overall appear attractive over a three-year investment horizon and are trading close to their median spread levels as of this writing.
Since my last outlook, many areas of the credit market have rallied on optimism that moderating inflation would soon enable central banks to pause their rate-tightening campaigns. Following a decline in government bond yields and a compression of credit spreads, certain fixed income sectors look less attractive today than they did a few months ago.
Is the optimism warranted? I fear not. In my view, economic risks have not dissipated, and many developed market central banks appear more steadfast in their resolve to tame persistent inflation. Some of the credit market indicators I monitor have indeed improved at the margins, including rosier corporate management outlooks and declining commodities prices. But the monetary policy regime remains a headwind, and I suspect it will be very challenging for central banks to engineer a soft landing. Still, I see several potential opportunities in select higher-yielding credit sectors (Figure 1).
While I maintain a bias toward defensive positioning, I continue to see opportunities to potentially add value by selectively increasing credit risk and rotating among credit sectors.
Previously, some of the most attractive opportunities could be found in European contingent convertibles (CoCos), credit risk transfer (CRT) bonds, high-yield credit derivatives, and emerging market (EM) corporate bonds. Today, I see more compelling value in US non-agency residential mortgage-backed securities (RMBS), European credit and banks, and high-yield EM corporate bonds.
To be clear, I still believe credit market volatility and challenging liquidity conditions in the coming months could offer entry-point opportunities that are more attractive than I am seeing right now. It’s premature for central banks to “declare victory” over inflation, and I suspect we could be in for additional market volatility going forward. Accordingly, investors should be ready to move quickly if they wish to exploit market inefficiencies and credit dislocations that may arise, whether induced by central bank actions or by sudden, unanticipated market events. Above all, stay nimble.
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