Commentary from Insight Investment’s Head of Global Credit, Adam Whiteley, on the outlook for bonds / global credit.
How bonds are faring in the new inflationary environment
- Despite a backdrop of nagging recessionary fears and persistent inflation, global credit is looking more attractive to investors now than at any stage over the last 15 years.
- Yields are at a level we haven’t seen since the GFC. Interest rate risk is something we probably want to take for the first time in many years. Along with a decent credit spread, investors could potentially see good returns in something as tame as IG corporate bonds.
- US Treasury yields have drifted upwards since the start of the year, reflecting that markets had become too optimistic about the pace of the easing cycle this year and needed to adjust to a more realistic outlook. This trend may continue in the short term but we would view higher yields as an attractive entry point instead of a reason for concern.
- There is still at least some risk of an economic ‘hard landing’ in 2024, and if inflation proves sticker than expected this could have some serious negative consequences for both economies and global investors. Yet despite this possibility, we remain broadly upbeat on the prospects for fixed income markets. Investors can look to a number of positives, with companies and households financially strong.
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Outlook for bonds: higher yields offer asymmetric returns
- In our view, the neutral rate has shifted upwards, raising the range in which central banks will be conducting monetary policy in the years ahead. This could lead to two key consequences: the potential for monetary easing in 2024 is limited as policy is not currently as restrictive as many believe, and that tightening monetary policy sufficiently for it to truly tame inflation over the longer term is going to be difficult. Bond yields have risen to reflect this new reality, and we believe higher yields create a positively skewed, asymmetric return profile for fixed income investment. If yields continue to drift upwards, income is sufficient to absorb a degree of capital losses limiting the risk of negative returns, but if yields move sideways or decline investors should enjoy healthy returns from income, potentially further buoyed by capital appreciation.
- After years of low interest rates, markets are now back to levels where investors can more accurately assess risk and return prospects across a range of fixed income assets. Credit is an increasingly attractive prospect for global investors, offering both attractive yields and low default risk across global markets. We believe the high yields available in fixed income markets will attract more inflows from other asset classes in 2024.
Types of bonds to look out for globally: utilities and senior banks
- For the most part, different sectors move in sync, but there are certain sectors that move further ahead in their cycle or fall a bit behind compared to the rest of the market. The property sector, for example, has moved a lot further through its cycle, and is arguably pricing in more of a rolling recession than other sectors. As such, we continue to see pockets of value in the property sector, with a preference for subsectors where we see more favorable demand and supply dynamics such as logistics. We have started to reduce our long in the sector, given recent outperformance.
- Given that the next phase of the cycle is likely to involve less growth and lower margins, we also currently prefer more defensive / non-cyclical sectors such as utilities and remain underweight more cyclical sectors such as basics and energy, as we do not believe there is enough cyclical premium currently priced into credit spreads.
- We also continue to have an overweight position in senior banks due to attractive valuations and solid fundamentals. Although the first half of 2023 was very much characterised by concerns about the banking system, banks are in good shape. Capital ratios have been built since the financial crisis and both the quantum and quality of capital has improved significantly. There are still risks – digital banking has increased the speed at which deposits can be withdrawn, and that is a vulnerability that we need to be acutely aware of, but we don’t see a systemic problem within the banking sector as a whole. The latest concerns surrounding US regional banks and some of the German banks relating to their US commercial real estate exposure also appear to be idiosyncratic rather than systemic. When we look at valuations, spreads remain wide relative to non-financials, and within the range seen during the eurozone sovereign debt crisis. We think this creates an opportunity to be overweight banks and underweight non-financials.
Emerging markets / Asia Pacific bonds
- EM economies are arguably further ahead in their cycles as EM central banks were the first to hike rates and now they are the first to cut. Desynchronized cycles bring opportunities because they create value dislocations, and as active managers we take advantage of this. Whilst we think there are opportunities in some countries where yields are falling a lot of the directionality for EMs local yields will be determined by U.S. Treasuries, so they cannot fully disconnect.
- In local currency rates, we currently have a bias to be underweight Asia and overweight in Latam (Brazil, Peru and Mexico) and South Africa, as central banks in these countries have started cutting.
- EM hard currency continues to look expensive vs. history.
