As investors look to navigate through market uncertainty, we continue to advocate for positionings within quality and defensive segments of the fixed income market.
Ian Hui and Adrian Tong
- Fixed income valuation have re-priced significantly over the past year. With peak hawkishness priced in, duration risk has significantly come down.
- A focus on quality and defensive such as treasuries and investment grade (IG) makes sense given the economic uncertainty ahead. Investors don’t have to venture far out on the IG yield curve to obtain a decent yield.
- High yield spreads will likely widen further as corporate profitability declines and as economic activity slows
2022 has been a difficult year for markets, as the sharp rise in Treasury yields, widening credit spreads, and the deteriorating outlook for company earnings have weighed on both stock and bond returns.
Since the start of the year, MSCI World has declined more than 19.7% and the Bloomberg Barclays Global Aggregate has fallen more than 20.4% respectively. For investors, this positive correlation between stocks and bonds has challenged the efficacy of the classic 60:40 portfolio. However, with the bond and credit market already substantially re-priced, and a potential peak in Treasury yields in sight, pockets of opportunities are appearing within the fixed income space.
Treasuries are an important (bargain?) downside protection
Much of the negative performance in fixed income this year has been due to the volatility in rates. Since the beginning of the year, the MOVE index, a measure of interest rate volatility, has doubled from 75 to 145, while the 10-year Treasury yields has risen more than 231 basis points (bps). This has led to significant de-rating in the fixed income market given the inverse relationship between yield and bond prices. The re-pricing has been particularly prominent within the more liquid areas of the fixed income market such as sovereign bonds and Treasuries.
While the Fed will undoubtedly continue to step on the brake to contain inflation, further upside to Treasury yields is more limited now as the Fed’s tightening roadmap seem to be more realistically, or perhaps even overly, priced by the markets relative to a few months back. This has been reflected in the market pricing of the terminal Fed Funds Rate currently at 4.9%, up from 3.7% in August. With the bulk of duration risk already priced in, investing in Treasuries is now looking attractive particularly given the flight to quality that would take place if a recession unfolds. As the lagging effect of tightening monetary policy and higher lending costs clamps down on economic activity and dampens corporate profitability, government bonds will be an important defensive and liquid piece of an investor’s portfolio.
A focus on high quality as a more ‘natural’ credit cycle takes hold
Within the credit market, allocating to investment grade (IG) over high yield (HY), and a focus on quality companies makes sense given the less augmented credit cycle which will play out over the next quarter. While the Fed willingly purchased IG and HY to support credit markets amidst the volatility of 2020, it’s likely that a more ‘natural’ credit cycle will play out this time round as economic growth slows and the Fed’s mandate continues to be solely focused on taming inflation. While credit yields have jumped this year, spreads have been relatively contained, with most of the pressure coming from the rise in the risk free rate. As such, there may be further room for spreads to widen over the next few months.
Figure 1. U.S. investment grade* credit curve
Currently, U.S IG bonds are offering close to 6% yield, around 180 basis points over the risk-free rate, above its 10-year average of 154 bps. Within IG, short duration will help mitigate interest rate risk, and given how much the short end of the U.S IG yield curve has picked up (figure one), investors don’t need to take excessive duration risks to take advantage of higher yields. It’s estimated that more than a 330 bps rise in yields is required for bond price loss to offset the coupon payment on 1-3 year U.S. corporate IG bonds. In other words, Treasury yields will have to rise more than 3.3% in order for short duration corporate IG bond total returns to be negative – a scenario which is highly unlikely.
Figure 2. U.S. high yield spread-to-worst
We remain cautious on HY for now, despite U.S. HY offering 8.9% yield. HY spreads are at 454 bps above risk-free rate currently, however spreads have historically widened to the 800-1000 bps range during past recessions as shown in figure two. HY spreads have been well contained, and have in fact narrowed as of late, due to technical factors such as the influx of USD 107 billion worth rising stars, the largest annual total on record, and a decline in HY index par value due to slowing net new issuance. As economic conditions continue to tighten and bites down on corporate profits, higher refinancing costs and limited liquidity will weigh on highly levered, low-quality companies. This will inevitably push spreads wider.
As investors look to navigate through market uncertainty, we continue to advocate for positionings within quality and defensive segments of the fixed income market. Treasuries are looking reasonably priced, and with a Fed pivot in the not-so-distant future, interest rate risks are more limited than before. Within the credit market, we focus on IG over HY, and we continue to prefer short duration bonds as the short-ends have picked up enough to offer decent yields in the current flat curve environment.
Investors will want to begin tinkering the 40 in their 60:40 portfolio, building positions in the core duration and quality space of the fixed income market in order to take advantage of attractive pricing before Treasury yields enters an inflection point, as well as using this opportunity to build a resilient portfolio to navigate through a recession.