Fixed Income asset class overview

In the US, the Federal Reserve (Fed) hiked interest rates a further 25bps to put the policy rate in a target range of 4.75-5.00%, while adding in their statement that “additional policy firming may be appropriate”. This was softer than the earlier language, which stated that "ongoing increases in the target rate will be appropriate". The pace and asset make-up of quantitative tightening (QT) was unchanged as expected.

In Europe, the European Central Bank (ECB) followed through on their previous commitment to hike by 50bps, which took the deposit rate up to a post-2008 high of 3%. ECB President Lagarde said this was supported by a “large majority” of the governing council members, but in other respects the decision was a dovish one, in our view. The ECB’s statement dropped the previous guidance that they expected to raise rates further. Instead, the message was that they would take a “data-dependent” approach at subsequent meetings.

The Bank of England hiked rates by 25bps as expected, taking the bank rate up to a post-2008 high of 4.25%. Seven of the nine MPC members were in support, with the other two members preferring to remain on hold. Looking forward, the Bank said that they still expect inflation “to fall significantly” in Q2, aided by falling energy prices and the government’s move to extend the Energy Price Guarantee in the recent budget.

Inflation

CPI numbers remain stubbornly elevated in the UK, increasing to 10.4% in February. Euro CPI showed signs of moderation and fell slightly on the month (8.5%). US CPI (6.0%) continues to show signs of slowing, although stickier components remain somewhat elevated as measured, for example, by core and median CPI, with inflation also looking broad-based. Developed labour markets also remain strong, with wage increases meaning inflation may remain at elevated levels for some time. On the other hand, money supply is coming down, which should mean the overall trajectory is downwards.

The volatility in the banking sector led to the market sharply repricing its expectations of how much central banks will raise interest rates. Market participants lowered their rate hike expectations, even pricing in rate cuts by the start of next year as the banking sector problems led to a tightening in financial conditions. However, this somewhat reversed in the latter part of the month as the market subsequently stabilised. Inflation expectations, as measured by breakeven rates, fell during the middle of the month following the same narrative, but subsequently rose again.

We continue to think that central banks will remain under pressure to keep rates elevated for some time. The sticky part of the inflation basket (mainly services) remains extremely elevated, while core goods, whose prices had been falling over the last few months, made a comeback, posting a positive number recently.

While we remain in a disinflationary environment, there is still lots more work to do before we can finally claim victory over inflation. Going forward, we believe we can expect inflation generally to continue to trend lower driven by core goods, although core services will likely remain sticky, putting a floor under where overall inflation will settle.

Where will the terminal rate be?

The “terminal rate” is the rate at which central banks will finally stop hiking rates.

The Fed doesn’t know exactly where they should stop. They hike rates and then see how the economy responds. The data we have been receiving so far this year suggests there is still more work to do: growth estimates keep getting revised higher and inflation is not coming down as fast as the Fed was hoping.

The Fed is data-dependent and the economic data they have received so far this year will make it difficult to stop hiking just yet.

Investment grade credit

Warren Buffett famously said “it’s only when the tide goes out that you discover who has been swimming naked”. Well, this month we identified a few naked swimmers! This is typical when rates go up, as tighter financial conditions put pressure on companies and bring out the poorly managed ones, such as Silicon Valley Bank.

Banks clearly underperformed this month, with Additional Tier 1 (AT1) instruments suffering heavy losses, after the Credit Suisse AT1s were written down to zero.

The uncertainty around banks has also put pressure on the broader credit market, with spreads widening. Spreads for the Global IG index widened by around 20 bps in March, although the index was up over the period as the duration component more than offset losses coming from credit. 

The Global Investment Grade index now trades with a spread of 153bp. Overall yields remain historically high. The EUR IG index currently offers a yield of 4.2%, the GBP IG index yields 5.6%, while the US IG index yields 5.3%.

Going forward 

Concerns over the banking sector showed signs of easing towards the end of the month and risk assets recovered part of their early losses. Lower volatility should be supportive for credit, although it’s hard to expect a smooth ride from now onwards. The road ahead will likely remain bumpy, with inflation and recession risk dominating the scene.

From one side, inflation is heading in the right direction, reflecting the sharp fall in money supply. This is positive for fixed income markets. On the other hand, the risk of a recession remains elevated as central banks continue to tighten financial conditions.

In this environment of elevated uncertainty, we think investment grade credit offers investors balanced and diversified qualities. Not only has the IG market grown considerably over recent years - becoming highly diversified and liquid in the process - but it also offers natural diversification qualities, in our view, thanks to its duration and credit components. This has already been evident this year: despite spreads rising on the back of the recent banking turmoil, the asset class has still managed to generate positive returns thanks to its duration component.

Moreover, the yield available from the IG market remains historically elevated, providing investors with a good overall cushion to further absorb future volatility, in our view.

Past performance is not a guide to future performance.

High yield credit

It was a volatile month for high yield markets, as turmoil in the banking sector sparked fears about broader contagion across the financial system. Spreads on the global HY index widened to 522bps post the CS/UBS merger, compared to below 400bps earlier in the month, but then recovered some of that widening towards the end of the month.

Global HY markets returned around 0.6% during the month. Regionally, European HY underperformed due to greater exposure to the banking turmoil. US HY outperformed, supported by lower rates and a strong market technical. Global HY FRNs were broadly flat.

Higher quality bonds outperformed whilst distressed issuers, rated CCC and below, lost around 2.0%. Sector performance was mixed, with banking, retail and pharma underperforming the rest of the market.

Primary activity remains light, with most supply coming from higher-rated issuers (BBs). Interestingly, in Europe, Green, Social, and Sustainable (GSS) issuance is running at €6.3bn so far in 2023, which represents a record 39% of total deal flow.

There were no defaults this month, although there was one ‘fallen angel’ in the US, with Nissan being downgraded to high yield. On the other hand, Netflix and Seagate were upgraded to IG and therefore left the HY index.

Current market view

• Banking turmoil hasn’t brewed into a full-blown crisis thanks to the speedy response from regulators. Whether it will trigger further credit tightening, and/or even bring forward a recession, remains to be seen.
• We remain generally neutral on valuations. We believe technical elements (supply/demand imbalance, attractive all-in yields) remain supportive and are helping to contain spreads.
• Fundamentals are also generally supportive for now, in our opinion, although we need to work closely with analysts to avoid issuer-specific blow-ups.
• We expect a more shallow default cycle versus what is currently being priced in by markets.
• We are generally concentrating on higher-quality issuers and non-cyclical sectors, such as healthcare and technology, media and telecom (TMT).

Past performance is not a guide to future performance.