Income Asset Management’s Head of Credit Strategy – Matthew Macreadie, provides his credit outlook for 2023.
It is the starting point that counts
- After enduring one of the worst years on record, bond investors should find more cause for optimism in 2023. Bond yields are likely to remain relatively high at least through the first half of 2023. Higher yields enable bonds to play their historical role once again as a source of reliable, low-risk income. For the first time in decades, bond yields are high enough that income-seeking investors can use them to support a 5% withdrawal rate from their portfolio’s.
- Not only are yields up, but prices of many high-quality investment-grade bonds are down as a result of the 2022 selloff resulting in a smaller cash outlay.
- Furthermore, investment-grade corporate fundamentals remain solid with leverage metrics at a low and interest coverage at a high last seen pre COVID-19.
- However, the opportunity presented by higher interest rates could be short lived.
- The US Federal Reserve also wants to ensure it has room to cut interest rates if the economy goes into recession. Interest rate cuts are the key tool that the US Federal Reserve has to stimulate economic growth and the central bank would like to be able to make impactful cuts when necessary.
- That could mean that the opportunity to add low-risk, high-yielding investment-grade bonds to an income strategy may not be there if you wait too long.
For many bond investors, 2022 was a horrible year. It was the first time since 1994, both global bonds (fixed rate) and equities fell in a calendar year as rising interest rates and skyrocketing inflation killed the academic negative correlation between these two asset classes. Many economic commentators have even suggested the so-called 60/40 portfolio isn’t an appropriate solution for future portfolio construction. We would caution these comments and argue that longer-term relationships between these two asset classes should be relied upon rather than the recent short-term market behaviour. As we have highlighted below, it is the starting point that counts.
Chart 1 – US Equity vs Government Bond Annual Returns
Source: IAM Capital Markets, BondAdviser, Bloomberg. As at 31 December 2022. US Treasury Returns uses the Bloomberg US Treasury Total Return Unhedged USD Index (or LUATTRUU Index).
Chart 2 – Australian Equity vs Composite Bond Annual Returns
Source: IAM Capital Markets, BondAdviser, Bloomberg. As at 31 December 2022. AusBond Composite Bond Index Returns uses the Bloomber AusBond Composite 0+ Yr Index (or BACM0 Index).
Over 2022, Australia equities outperformed US equities, as Australia’s overweight raw material exposure provided downside protection. Global supply constraints and excessive commodity prices resulting from the conflict in Ukraine have only further exacerbated inflationary pressures already present following loose monetary policy implemented globally. From a bond perspective, the significantly higher credit quality and lower duration of the corporate bond market in Australia compared to the US, saw less repricing of bonds in the market-wide rout.
The key to understand is that each equity market selloff historically has had a different cause – whether this be due to an economic, financial or liquidity event. However, the 2022 equity market selloff was driven by skyrocketing inflation which had negative implications for nominal bonds returns – therefore, both bonds and equities were sold-off. This has created an environment where rising interest rates have made new bond investments increasingly appealing. Looking at the large-developed bond markets of the United States and Australia, we can see that investment-grade bond yields are now well above recent historical levels.
Chart 3 – US and Australian Investment-Grade Bond Yields
Source: IAM Capital Markets, Bloomberg. As at 31 December 2022. AU IG Corp is derived from ICE BofA Australia Corporate Index (or AUC0 Index). US IG Corp is derived from ICE BofA US Corporate Index (or C0A0 Index).
The extensive repricing of bonds and higher starting yields can help insulate bond investors from further losses. With the market yield now in the 6% area, history shows that future returns for bond investors are likely to be appealing from here. Future returns are obviously not fail-safe, but it is fair to say bonds yields should provide a better shock-absorber going forward than they did in 2022. Bond investors no longer have the benefit of policy-based shock absorbers, like Quantitative Easing (QE) and low interest rates. Therefore, in the absence of monetary and fiscal stimulus, bond investors need to find other ways to shock proof their portfolios.
Based on the dataset below, if the prior starting yielding was 6%, then the implied forward 5-year annualised return was 6% when including 1986-2022. There are some statistical pitfalls of this analysis but this illustrates the positive convexity in US bonds currently with beaten down bond prices.
Chart 4 – 5-Year Annualised Return vs Starting Yield, US Broad Market Index, 1986-2022
Source: IAM Capital Markets, Bloomberg. As at 31 December 2022. We use yield to worse for calculation of starting yield. The US Broad Market Index is derived from the Bloomberg US Agg Total Return Value Unhedged USD Index (or LBUSTRUU Index). The 5-Year Annualised Return uses the formula: = ((1+1-Year Return)^(1/5))-1. We note the “Were Here” value is taken 12 months ago, of 31/12/2022.
In a relative sense, bond yields also look attractive when viewed against other asset classes. We have heard from many commentators that the dynamic of “there is no alternative” (TINA) to equities is now no longer an issue. For comparison, the relative yield of US bonds over US equities, has risen to around 4% providing a viable alternative to US equities. Although not charted below, this association is also present in the relative yield of Australian bonds over Australian equities.
Chart 5 – Difference between US-10 Year Bond Yield and S&P500 Dividend Yield
Source: IAM Capital Markets, Bloomberg. As at 31 December 2022. US-10 Year Bond Yield derived from US Generic Govt 10 Yr (or USGG10YR Index).
The prospect of higher incremental relative yield becomes even more pronounced as you go down the risk or credit curve. The chart below shows that high single digit returns [7-10%] are now available across several higher-risk asset classes, including US HY Credit, Global HY Credit and EM Credit. It is critical to note these higher-risk asset classes do have a higher correlation to equities and are susceptible to an equity market selloff. Nevertheless, the current yields offer more downside protection than has historically been present especially with corporate fundamentals remaining solid. For example, within US HY Credit, leverage metrics are near a low last seen in 2019 and interest coverage is at a record high.
Chart 6 – Current Yields on Bond Asset Classes
Source: IAM Capital Markets, Bloomberg. As at 31 December 2022. Various Bloomberg Index proxies are listed below. We use yield to worst across the bond indices and a forward earnings yield for the SPX Index. US Treasuries LUATSTAT Index, US Core Bonds LBUSTRUU Index, IG Credit LGDRTRUU Index, Agency/MBS LUMSTRUU Index, US HY Credit H0A0 Index, Global HY Credit LG30TRUU Index, EM Credit EMCB Index, Equities SPX Index.
Another dynamic in the current environment is that most of the high-quality bonds are trading at discount to par translating into compelling positive convexity profiles which should stimulate overall investor demand. This is a result of lower-coupon bonds enduring the path to higher interest rates and significantly falling in price terms. With many corporates having largely termed out their debt profiles at low interest rates over 2020 and 2021, the supply backdrop should also be positive for bonds.
Chart 7 – US Investment-Grade Credit Spreads and Price
Source: IAM Capital Markets, Bloomberg. As at 31 December 2022. Asset Swap Spread (Bps) and Price derived from Ice BofA US Corporate Index (or C0A0 Index). Price reflects “clean price” for completeness.
We have started to see a slowing in bond outflows as inflation eases and hopes rise for the end to interest rate increases, largely from the US Federal Reserve. Over US$500bn flowed out of US fixed income mutual funds over 2022, a record according to data compiled by the Investment Company Institute. While some outflows transferred into exchange traded funds, the vast majority was retail money.
The latest US CPI data released provided meaningful evidence that inflationary pressures are beginning to slow in the US, as the December release showed that headline CPI rose 6.5% year-on-year (YoY), while core CPI rose 5.7% YoY. On a month-on-month (MoM) basis, headline CPI was deflationary for the second time of 2022, falling 0.1%, while core CPI rose 0.3%, noting that falling energy prices were the driver of a lower headline figure.
Since the December CPI release, markets are now pricing a higher probability of a 25-bp interest rate hike when the US Federal Reserve meets in February – pointing to another step-down in the pace of interest rate hikes after slowing down to 50bps at the December 2022 meeting.
Chart 8 – US Inflationary Pressures Showing Signs of Easing
Source: BondAdviser, Bloomberg. As at 31 December 2022
Importantly, when annualising the quarter-on-quarter (QoQ) US CPI data, inflation is only 1.8% on a headline and 3.1% on a core basis. Annualising more recent data provides a deeper insight into the medium-term outlook on inflationary pressures (whereas the commonly reported figures are based upon last year’s prices), which is pointing to one thing: inflationary pressures are appearing to be slowing in the US. Domestically, this is unlikely the case yet, given that inflation took off sooner in the US than Australia (i.e., US is later in the cycle), and considering that the US provides more reliable monthly inflation data (ABS monthly measure of CPI is still a work in progress).
Chart 9 – US CPI Annualised QoQ
Source: BondAdviser, Bloomberg. As at 31 December 2022
Finally, there is precedent for a rapid recovery in bonds. US corporate bond prices rebounded faster than US equities after the 2008 crisis. However, many economic commentators are now predicting a US/global recession over 2023, which would put strain on corporate bonds through increased risk of defaults. Market indicators, including the spread between 2-year and 10-year US government yields, are currently pricing in US recessionary risks. Therefore, it is imperative for bond investors to use this opportunity to get set in sufficiently higher quality areas of the bond market.
In terms of US HY credit spreads, markets have certainly calmed since peak panic in 2022. Since the end of December 2022, credit spreads in the US HY space have tightened 54bps to 431bps respectively and have continually compressed a total of 132bps without reversing since the peak in September 2022. While this data is consistent with markets toning down inflationary fears, it is inconsistent with a deteriorating macro backdrop given many are expecting a US/global recession over 2023.
In the future though, we may inevitably look back and see 2022 as a horrible year but 2023 as the starting point for bonds that really counted.
Chart 10 – US Corporate High Yield Z-Spread
Source: BondAdviser, Bloomberg. As at 15 January 2023. As at 15 January 2023. Z-Spread (Bps) derived from Bloomberg US Corporate High Yield Total Return Index Value Unhedged USD Index (or LF98TRUU Index).
This article originally appeared here.
