30 September 2022
From chaos comes opportunity?
With bond yields reaching our forecasted levels sooner than expected following recent central bank interventions and government policy announcements, we evaluate whether it’s time to shift positioning.
Fundamentals
The UK government’s budget announcement in response to the cost-of-living crisis triggered the transition from a disciplined sell-off to distorted market conditions. Investors are questioning contradicting dynamics, with the Bank of England raising interest rates and implementing quantitative tightening measures on the one hand, while the UK government is effectively trying to minimise the impact on growth and shield consumers on the other. The UK is now in a tight spot as borrowing costs have increased and markets are questioning the credibility of the government’s actions. The current situation in the UK also implies the market's reluctance to fund fiscally unviable fiscal policies. The repricing we have seen across rates markets and – as a consequence – the rise in debt funding costs may force governments to balance their books. Given these dynamics, volatility is expected to remain elevated for the foreseeable future.
Quantitative valuations
Rates markets have undergone a sharp repricing over the past week, with volatility at levels last reached at the peak of the Covid pandemic in 2020. Ten-year US Treasuries delivered a -1% total return week on week, as yields rose to a decade-high 3.75%. In the UK, 10-year Gilts are currently yielding 4%, a level not seen since 2008 after recording a total return of -10.4% over the last week. This repricing is also evident in global credit markets: the yield on global high yield has reached 9.8%, the highest level since April 2020, while the yield on global investment grade credit has touched the highest level since 2009 at 5.3%. However, while yields are moving closer to sufficiently pricing recessionary risks, credit spreads have not yet been affected to the same extent. Investment grade credit spreads are only 11 basis points (bps) wider month-to-date, while high yield spreads are 22bps higher. Effectively, yields in the credit market may appear attractive at the headline level, but we think spreads still have scope to widen further. Data as of 27 September.
The recent re-pricing in high yield has been driven by core government bond yields more than credit spreads
Source: Bloomberg; data as of 27 September 2022. Chart shows global high yield year to date cumulative total return. GHY: ICE BofA Non-Financial Developed Markets High Yield Constrained Index (HNDC).
Technicals
The technical backdrop remains weak, with poor liquidity across markets, which may be at least a partial reason why credit spreads have not yet widened materially. Our internal flows monitor shows that high yield and investment grade funds each have experienced net outflows of approximately USD 5 billion month to date (to 22 September). Investors have largely prepared for these outflows by building up high cash balances, which have been able to cushion the impact of redemptions. However, we are mindful of the additional pressure the market could experience if outflows persist and managers need to sell cash holdings to meet redemptions. Meanwhile, market volatility has deterred companies from opportunistically issuing debt: supply in US investment grade has only been about USD 77 billion month to date (to 27 September), compared to expectations for USD 125 billion to USD 150 billion, while European issuance has been close to non-existent. There has also been a lack of issuance in high yield, with only two non-financial deals coming to the European market so far in September. However, the significant increase in current financing costs vs. bonds that were issued in the last few years could reveal the pain issuers may have to face if they need to tap the high yield market in the near term.
What does this mean for fixed income investors?
While markets appear to have shifted into disorderly territory, we stress the importance of staying focused and maintaining a long-term perspective. With yields at levels not seen in decades, investors may be tempted to revisit fixed income positioning. However, we remain concerned by the ongoing persistence of inflation and the tightening pathway of central banks. In this environment, we expect market volatility to continue, eventually impacting corporate fundamentals. As a result, we are not yet tempted by the higher all-in yields in the riskier parts of the corporate credit market; instead, we maintain our preference for short duration, high quality cash flows.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors
include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations
is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors
are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum