Insights
Putting Income Back into Fixed Income
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Global Fixed Income Bulletin
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October 27, 2022
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Putting Income Back into Fixed Income
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October 27, 2022
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Putting Income Back into Fixed Income
Putting Income Back into Fixed Income |
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The bond market rout continued in September, which would have been even worse without a substantial rally over the last three days of the month. Bond market woes were caused by a litany of factors: better than expected U.S. employment, worse than expected inflation, the U.S. Federal Reserve (Fed) raising expected terminal rates meaningfully. These factors were compounded by the now infamous UK bond market meltdown over the second half of the month. Sovereign yields and credit spreads moved substantially higher in September. Credit markets were clearly impacted by the rise in yields, turmoil in the UK, and, maybe most importantly, the rising probability of a recession or hard landing. Also, not surprisingly, the U.S. dollar was strong once again, rising in value against almost all of the world’s currencies. That’s the bad news.
The good news is that yields across the fixed income universe reached levels that should provide decent protection against further rises in yields. For example, high quality 10-year investment grade financial debt now yields around 6%. Even if yields/spreads rise another 50-75 basis points (bps), total returns over 12-month periods should be positive—a major change from the beginning of the year. And, we believe, eventually the economy will soften, inflation pressures ameliorate and government bond yields will fall, further cushioning the impact of potentially wider spreads.
The news in September was generally negative for bonds. Whether it was a U.S. labor market showing no imminent signs of softening, or U.S. inflation (core CPI) rising from a 0.3% month-over-month change to a 0.6% month-over-month change. News from Europe and elsewhere also remained poor on the inflation front. It is likely. In our view, that Eurozone inflation will stay in double digits into 2023 at least. And, with fiscal policy easing to varying degrees, headwinds for monetary policy are likely to get a bit stronger given additional fiscal support to households and businesses. It seems nowhere in advanced economies is there optimism that central banks have hiked enough. Even in Australia, where the central bank surprised markets by “only” raising rates 25 bps rather than the expected 50 bps, the cumulative amount of tightening the central bank expects to deliver remained unchanged.
The impact of poor inflation data was felt particularly hard on real yields. The U.S. 10-year real yield rose almost 100 bps in the month, an amount rarely seen in any one-month period. This of course implied that inflation expectations fell over the month (nominal 10-year yields did not rise as much, meaning 10-year breakeven inflation spreads fell). This suggests the Fed has gained credibility in its inflation fight. In other words, the market increasingly believes Fed rhetoric that it will raise rates to “whatever it takes” to bring inflation down to target (circa 2%). It also implies higher probability of a recession in 2023 or a long period of subpar growth as that is what it usually takes to push inflation meaningfully lower.
Markets were additionally challenged by events in the UK. An unprecedented wave of selling, first of long-dated UK government bonds and then other Euro and USD denominated bonds, led to wild gyrations in UK government yields and significant price deterioration in corporate and securitized bonds. For example, the UK 30-year government bond yield was rising steadily over the month until September 27/28, when it suddenly rose 94 bps, only to fall 105 bps on September 28, after the Bank of England (BoE) announced it would buy billions of pounds of long gilts to ensure financial stability. While it clearly worked to stabilize the market, subsequently, 30-year gilt yields are back up 46 bps as of October 7. The index linked gilt market, a large market mostly used by UK insurance companies and pension funds, had even worse volatility. This episode was the first example of something “breaking” from the rapid rise in yields in 2022. Of course, it does seem leverage was the trigger, as it usually is during financial crises. Whether or not there are other skeletons lurking in investors’ closets remains to be seen.
Fixed Income Outlook
The biggest takeaway from events and market movements in September is that it is too early to talk about central bank pivots and lower inflation. It seems that rate hikes as currently forecasted by major central banks are likely to be the minimum we can expect given the stubbornness of inflation and firmness of labor markets. The U.S., despite its significant economic slowdown this year, still has a large imbalance between aggregate demand and supply, not just in the labor market but in the economy overall. While it is not experiencing the energy shock Europe is facing, the trend in U.S. wages and hiring (both actual and intended) look to be too high, requiring the upgraded Fed rate forecasts and predicted path of hikes for the remainder of this year. They have also forewarned there will be more to come if this path does not suffice. Given that inflation remains stubbornly high, financial conditions, meaning rates, longer-maturity yields and credit spreads need to stay at elevated levels for a material period of time in order to grind down inflation. This will prevent any sustained rally in yields and spreads. The rallies we have seen, in July and over the last few days of September, have proven to be short lived as the hoped for Fed pivot did not come.
Of course, as the Fed ups the ante so to speak, the probability of an overshoot (tightening too much) grows, which could result in a significant economic slowdown, or a financial accident. The volatility witnessed in the UK in recent weeks is something of a warning shot for investors to get their financial houses in order to withstand higher yields. As per usual, stresses in the system and negative feedback loop to the economy are due to leverage. The issue in the UK bond market was not about solvency but about leverage. It was about borrowing to increase returns. Live by the sword, die by the sword. It is difficult to know how much private sector financial leverage exists in the global economy, but the degree to which there will be dispersions of performance will likely hinge critically on who has the most levered or least levered investment or business model. The Fed has been clear about this. Get your balance sheet/investment portfolio prepared for a slower economy and higher, sustained yields.
Over the past 25 years, when problems arose, central banks, particularly the Fed (the world’s central bank) provided a put which markets could exercise if times got really tough. If rate hikes caused too much pain they would be reversed quickly. However, today the situation is the opposite. There is too much inflation. Too much demand. Too little supply. Too low unemployment rates. Without saying so explicitly, central banks will welcome higher unemployment if it helps reduce inflation. What this means is that unless there is a dramatic change in the economic/labor market situation, modest improvements in job openings, hiring, even inflation will not cause the Fed to pivot. And, improvements will have to be sustained over many months.
What does this mean for bond markets? European bonds remain challenged by the highest inflation rates in the world. Usually we think of Europe as being a poster child for low inflation and secular stagnation. Now, we have stagflation. Bonds, in or view, will continue to struggle as the European Central Bank (ECB) attempts to raise rates enough to bring down inflation while acknowledging that a significant portion of inflation, maybe 40- 50% is due to factors (energy) they cannot control. But, what they cannot do is allow an inflationary spiral and let current inflation become embedded in the economy, even at significantly lower levels than today. The good news is that bond markets mostly understand this and price in meaningful increases in interest rates, as do credit spreads. Unfortunately, it is too early to declare the all-clear. Risks are likely still skewed to even higher yields even at the expense of a deeper economic downturn.
The U.S. economy looks to be amongst the most resilient of advanced economies. This is both good and bad. It means U.S. credit markets remain in good shape fundamentally in that corporate. But it also means that robust private sector balance sheets and income generation will make it harder for the Fed to slow the economy. While it is still possible that a soft landing will be achieved, it becomes more difficult. There is little to stop 10-year U.S. yields from breaching the 4% level over the remainder of the year. And, while bonds are no doubt more attractive than they were in July, we are wary that there is more pain to come and investors should remain patient in adding interest rate and credit risk to portfolios. Most emerging markets, while further along the rate hiking path, remain in the throes of too high inflation and more rate hikes.
Developed Market Rate/ Foreign Currency
MONTHLY REVIEW
September was anything but boring when it came to developed market rates. Yields broadly were higher, while volatility reached historic levels. Notably, the U.K. bond market faced serious disruptions following tax cut announcements and an implosion in pension funds, which permeated across global markets. In general, central bankers across the world made it clear that combatting inflation was their sole focus, even if it meant that growth may have to slow. As a result, yields, especially real yields, rose.1
OUTLOOK
As central banks continue to tighten monetary policy, it seems more and more unlikely that a “soft landing” can be achieved. As a result, rates are likely to remain higher for longer, but volatility across markets is also going to continue as uncertainty remains. Regarding foreign exchange, the U.S. dollar has benefited from the tighter Fed policy and growing global growth concerns, and we believe this will continue.
Emerging Market Rate/ Foreign Currency
MONTHLY REVIEW
Emerging Markets Debt (EMD) took a turn in September following a rally from mid-July to mid-August. The corporate index within the EMD universe was once again the best performing. Rising U.S. Treasury yields directly hurt both hard currency indices further given their relatively long U.S. duration profiles.2
OUTLOOK
The macro environment remains quite challenging with hawkish monetary policy from most central banks, slowing global growth, a strong U.S. dollar, China slowing and the ongoing Russia/Ukraine war. We expect macro market events to continue to drive market sentiment. That said, valuations across the EMD universe seem to be pricing in these risks more aggressively than many other areas of global capital markets. We will watch the results of the 20th Party Congress carefully and expect President Xi to maintain his ultimate authority. We expect markets to place an emphasis on differentiation amongst countries and credits.
Corporate Credit
MONTHLY REVIEW
U.S. IG corporates outperformed Euro IG corporates. Generally, financials underperformed non-financials, BBBs underperformed higher-rated, and short-dated paper widened more than longer-dated. Market drivers in the month continued to be the macro, as markets reacted to actions and forward guidance of Central Banks in response to the elevated inflationary environment. 3
The tone in the high yield market continued to sour in September amidst growing concern over the forward path of monetary policy. Trading volume remained relatively light and investors tended to favor a move up-in-quality as economic concerns mounted. The higher quality segments of the high yield market generally outperformed. The top-performing sectors for the month were transportation, energy and electric utility.4
Global convertibles fell with other risk assets in September. The Refinitiv Global Convertibles Focus Index ended the month down though outperforming both MSCI Global equities and the Bloomberg Global Credit index. Convertibles demonstrated good convexity in the past quarter as bonds reached their bond floors and exhibited more downside stability.5
The senior floating-rate corporate loan market maintained its leadership position against the backdrop of volatile capital markets in September, outpacing the deeper losses broadly experienced in equity and fixed income markets at large. Loans were not immune to September’s gloomier investor sentiment and flight-to-quality positioning, however.6
OUTLOOK
Looking forward, market valuations are pricing a very negative outcome for corporate downgrades and defaults. We view corporate fundamentals to be resilient and companies as having built liquidity in recent quarters and implemented cost efficiencies under the COVID-era. We expect margins to be pressured and top line revenue to be challenging but given the starting point we believe corporates will be able to manage a slowdown without significant downgrades or defaults (base case low default and mild recession).
We remain cautious on the U.S. high yield market as we enter the fourth quarter. The health of corporate fundamentals should begin to decline amid slowing global growth.
The current level of defaults and distress remain low albeit are rising. It will be important to reassess issuers and rebalance portfolios in light of the potential risks ahead, while at the same time positioning for solid performance through the credit cycle. We believe careful credit risk management is the best course to navigating this market.
Securitized Products
MONTHLY REVIEW
September was another difficult month, as interest rates rose sharply again, and both agency MBS spreads and securitized credit spreads widened further. Securitized portfolios outperformed most other sectors as their shorter durations lessened the mark-to-market impacts and higher cashflow carry also helped offset losses. Current coupon agency MBS spreads widened and the Bloomberg MBS Index return was negative. U.S. Non-agency RMBS spreads also widened in September, as distressed selling and increasing liquidity concerns weighed on the markets. U.S. ABS spreads were slightly wider in September, despite being supported by the lack of new issuance. U.S. CMBS widened too as fundamental credit conditions remain challenging. European securitized markets remain under pressure and European securitized spreads widened significantly over the month.7
OUTLOOK
Our fundamental securitized credit outlook remains positive. We believe securitized credit spreads now offer attractive risk premiums for risk. Credit spreads for many securitized sectors remain at levels last seen at the depths of the pandemic, but credit conditions appear materially better today than during that period.