3 min read 26 Apr 23
The past several months have been erratic, with global bond markets in fluctuation. With more than 20 years of fixed income investing, Richard Woolnough shares how the current markets shape his outlook and strategy for flexible bond investing. Three key takeaways for bond investors to note:
After a decade of zero or negative interest rates in developed markets, inflation has jumped and central banks have had to reverse course and hike interest rates aggressively. As a result, government and corporate bond yields have risen dramatically, and bond prices have fallen with a similar velocity. Following this market correction, the starting point for fixed income investors is now much stronger today than it has been for a very long time. For example, investors can now achieve a yield of around 5.3% for investing in US investment grade (i.e. high quality) corporate bonds, close to the highest level in over 10 years and higher than at the peak of the COVID-19 crisis. In our opinion, this attractive level of carry, while not preventing volatility, constitutes a great entry point into the asset class.
Past performance is not a guide to future performance.
Indeed many central banks have been forced to raise interest rates significantly in order to curb rising prices. While this has exacerbated bond market volatility, inflation – especially excluding food and oil prices – has remained stubbornly high. In our opinion, the ultra-loose monetary policies and stimulus measures implemented during the COVID-19 crisis are the main reason for the elevated inflationary pressures we are seeing today. These measures, while often necessary, have resulted in significant excess liquidity across the globe.
History teaches us that whenever money supply increases, inflation has subsequently gone up. Conversely, if we reduce the supply of money, prices will fall. After a delayed lift-off, central banks and governments have now finally started to reign in this excess liquidity, through higher interest rates and quantitative tightening. While large accumulated household savings have meant that consumers have been quite resilient so far, ultimately we believe that reducing the money supply will cause inflation to come down, and the path is heading in the right direction. We would also add that given the current tight labour markets, we could potentially see inflation declining further without unemployment rates necessarily shooting upwards.
After a significant re-pricing in both credit spreads and the risk-free rate throughout 2022, we think investment grade credit now offers some good value. For perhaps the first time in over a decade, we believe investors are being well paid to take both credit and interest rate risk. Investment grade corporate bonds also look well placed to withstand an economic downturn, as corporate fundamentals remain strong and we expect default rates to stay low.
In addition, as we near the end of the rate hiking cycle, we are likely to see central bank monetary policies increasingly diverge and move in opposing directions at different times. In our view, this opens up a really interesting opportunity to generate performance by being highly selective and investing across regions.
Finally, within corporate bonds, dispersion across sectors is also at very elevated levels. Credit valuations can differ quite dramatically between sectors such as real estate and financials, where spreads remain quite wide, and other sectors such as health care and capital goods where spreads are significantly tighter. Within financials, we also have a preference for larger, more liquid and better capitalised banks, that could potentially benefit from the recent banking stresses we witnessed in March. As a result, top down asset allocation will remain important but it is likely that bottom-up security selection will also have an important role to play. We believe that a global, flexible and selective approach will therefore be key to unlocking returns and we have the full resources of our expert credit research department to support us here.
The biggest change across the unconstrained strategies last year was to increase the duration (the level of interest rates risk) of the portfolio. As yields sold off, we added duration and we now have much more interest rate sensitivity than in the past. Currently, most of this duration come from European assets as we believe inflation in the Eurozone will fall faster (compared to the US for example where inflation is stickier in nature).
For now, our view remains that central banks can potentially bring inflation back down to target without creating a significant economic downturn, although this may take some time and financial markets may be subject to bouts of volatility. As a result, while there is some exposure to high yield credit within the unconstrained fixed income strategies we manage, our most constructive long-term conviction is in investment grade corporate bonds, which we believe offers natural diversification qualities and a source of resilience during uncertain market conditions.
The views expressed in this document should not be taken as a recommendation, advice or forecast.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.