James Vokins and Chris Higham from our credit team believe the path of inflation will remain the central question for investors in 2023. Fixed-income investors should remain cautious until that path is more certain, but fundamental analysis can still uncover attractive opportunities.
Read this article to understand:
- Why interest rates are unlikely to revert to pre-2022 levels
- What that means for fixed-income investors
- How dispersion across credit markets will create selective opportunities
As developed economies came out of the global financial crisis, governments had accumulated a significant amount of debt as a consequence of bailing out their financial sectors. Potential paths to reducing these cumbersome debt levels could involve time, growth, inflation and defaults.
Governments initially embraced austerity, with disappointing results; there were some defaults, growth was hard to come by and inflation remained stubbornly low. But over the last few years, and particularly as COVID-19, geopolitical events and soaring energy costs forced governments to loosen their fiscal purse-strings, the central issue has been the trade-off between supporting growth and containing inflation. In 2022, it overshadowed all other questions.
With extremely low interest rates and trillions of dollars of negative-yielding debt at the start of 2022, fixed income was vulnerable to the inflation shock, which we saw playing out across markets throughout the year (Figure 2). In 2023, investors who are more positive on fixed income may have shifted their concerns to growth, but the inflation effect could prove far more significant.
The risks are inflation will remain higher and take longer to come down than some expect. As discussed in our latest House View, the inflation increases are double the growth declines (Figure 1). Despite the reassessment of valuations within fixed income in 2022, inflation remains a key concern.1
Aviva Investors’ James Vokins (JV), global head of investment grade credit, and Chris Higham (CH), senior portfolio manager, explain what this means for fixed income in 2023.
Figure 1: Change in consensus growth and inflation forecasts since the start of 2022
Source: Aviva Investors, Macrobond, Bloomberg. Data as of January 19, 2023
What will be the key theme for fixed-income investors in 2023?
CH: We are still concerned that, although inflation will come down, the reduction will be slow and volatile. The labour market remains tight, strikes are ongoing in several sectors, and wage increases are yet to come through.2 Even though real wages may not rise, nominal wages will. We are moving into a new regime where yields will be higher because fixed-income investors need more compensation for their risk exposure given this uncertainty around inflation.
Our central scenario remains a short and shallow recession
On the growth side, our central scenario remains a short and shallow recession. This still has implications for fixed income, especially within credit and lower-rated credit. We remain neutral on duration and credit risk, but with a short bias. Government bond yields are likely to go higher and credit spreads wider because of growth and inflation concerns.
On the valuation side, given the recent rise in yields, fixed income looks more attractive than it has been for a long time. There are arguments now is a good time to invest, but we expect more surprises on the inflation side and remain cautious.
Figure 2: Global high yield and global investment grade yield evolution, 2013-2023
Source: Bloomberg. Data as of January 2023
JV: This is a new era for fixed income and not a reversion to pre-pandemic quantitative easing and ultra-low rates. Just because inflation has started on a potential path lower, central banks’ forecasts of inflation coming back down to target in a short time is unlikely. On top of wage negotiations, there are other large structural drivers indicating inflation will struggle to come down to central banks’ two per cent target.3
Central banks need to maintain their credibility by showing they are following their mandate
Central banks also need to maintain their credibility by showing they are following their mandate. They will want to continue pushing rates higher to get inflation down, certainly for the first half of this year. As we saw in several instances in 2022, that creates a risk of over-tightening conditions, which could put pressure on financial markets and the economy.
The obvious example is the gilt market and liability-driven investing (LDI) issue that arose in September. But throughout 2022, pockets of weakness emerged, particularly in credit.4 As rates increase and liquidity diminishes, vulnerabilities get exposed, whether in real estate or anywhere excessive leverage has built up over years of ultra-low rates. They become problematic and markets are yet to work through that. The lower-quality end of credit, like high yield (HY), where there is a lot more leverage than in investment grade (IG) and government bonds, is an area where we could see strains developing or continuing.
How will the new monetary policy regime shape fixed income this year?
CH: After ten years of central banks buying assets, they are now selling them. We are in uncharted territory, and it is unclear how this exit is likely to go. It is happening against a backdrop of increased government borrowing and companies still needing to borrow, so its technical side is uncertain and a significant risk.
After ten years of central banks buying assets, they are now selling them
The only country where corporate bonds have been sold back to markets is the UK. That has gone quite well so far, but it is early days, and the European Central Bank (ECB) balance sheet reduction is only likely to start in the second quarter of 2023.5,6
The most significant consequence is that, after years of almost free money, governments are having to borrow at higher rates, potentially crowding out other asset classes. With US interest rates currently at 4.25 per cent but expected to rise to five per cent (Figure 3), how do you determine what compensation you need for fixed income, or indeed for any asset class? It is difficult, but valuations are likely to be lower, because the discount rate is a lot higher.
Figure 3: Market-implied Fed funds rate change between the end of 2021 and end of 2022 (per cent)
Source: Bloomberg. Data as of January 2023
JV: That is key. Over history, global HY has delivered two to three times more yield than IG, and five to six times more in Europe. Today, those multiples are around 1.5, even as some very solid short-dated IG names offer seven per cent, with little duration or credit risk. Given the risks, you would expect maybe double those yields in HY, but also more compensation for longer-dated IG bonds. We are not seeing those levels so, on a risk-adjusted basis, the front end of IG is where we are most comfortable investing (see Figure 2).
The front end of IG is where we are most comfortable investing
It may be a year of fantastic returns from duration or HY if the recession is not so bad and inflation comes down quickly; that is the risk to our view. But on a risk-adjusted basis, we don't think it is worth taking those exposures. We are neutral IG and slightly underweight HY, though there are obviously areas within HY we would expect to be resilient. Leverage across HY is not one-size-fits-all, and we have strong sector and single-name views.
Where do you see opportunities and risks?
JV: There is greater dispersion across the market than there has been for the last few years. Some areas of US IG, for example, are very expensive. Some names are trading at their early 2022 levels before the Russian invasion and market sell-off, while others in the same sector and market are trading at three- or four-times higher yields. That creates opportunities. Now is a better time to concentrate on the better risk-adjusted names than buying an ETF and just accessing the largest companies within the world of borrowing.
As discussed, from a top-down perspective, IG looks more attractive than HY and, within IG, we are overweight banks, which should benefit from higher interest rates. But there are concerns over the recession and potential losses, so we currently prefer the large money centres in the US and UK on a risk-adjusted basis.
We are cautious on areas like autos, retail, restaurants and leisure
Meanwhile, we are underweight cyclical sectors like real estate and consumer discretionary. Being so far down the value chain, the latter struggle with input costs and inflation more than industrials and are subject to the cost of living reducing demand. We are cautious on areas like autos, retail, restaurants and leisure. We tend to buy bonds of more stable companies less affected by the macro environment.
We also have limited exposure to energy. Depending on names, the sector did well over 2022 given cash levels and fundamentals have been strong. But that has probably run its course and we don’t see as much value there anymore.
And we are concerned about the supply of European government bonds and the ability of weaker countries with worse debt profiles to refinance, manage their debt load and attract financing from abroad as they issue billions more than they ever have done to fund COVID and cost-of-living crises. We are going through a policy change, not just on the monetary side, but also on the fiscal side, with more handouts and support for households, which will cost governments money over the next few years.7,8 That means more issuance and more crowding out, because if you can buy an Italian government bond for the same kind of yield as an Italian bank or corporate, you will probably choose the government bond. Overall, we expect debt metrics across Europe and the UK to considerably worsen.
CH: Curves are also very flat, delivering limited compensation for longer maturities or duration. In the sterling IG market, for example, the yield on nought to five, five to ten, ten to 15, and 15 to 30 years is virtually the same. Obviously, there is a lot under the bonnet, but overall, we prefer short-dated maturities (Figure 4).
Figure 4: Sterling IG yield curve change between the end of 2021 and the end of 2022
Source: Bloomberg. Data as of December 2022
What about defaults?
CH: As in every year for the last 15 years, some retailers will fall into trouble, but over the longer term, huge structural changes like flexible working will affect many areas. There are few sectors we are really confident in.
Utilities, a traditional safe haven for IG investors, are seeing large disruptions
Even utilities, a traditional safe haven for IG investors, are seeing large disruptions, whether it's windfall taxes on energy companies or clean, sustainable water regulation for water utilities.9,10 Their current financing structures are not adequate for these changes at a time when they are already suffering from inflationary pressures.
On the positive side, corporate margins are at all-time highs, meaning they can decline for a long time before causing defaults, particularly within IG companies where balance sheets tend to be stronger and margins higher than HY (Figure 5). On the default side, the next year or two should remain benign.
Figure 5: S&P 500 corporate margins (per cent)
Source: Bloomberg. Data as of January 2023
How far can yields keep rising?
CH: That comes back to the question of, “At what level are yields too high?”. With the LDI episode, we saw there was a level at which things started to unravel and policymakers had to step in, which was five per cent for 30-year gilts. But it is also a question of how fast yields rise in relation to how quickly leveraged investors can raise collateral.
We are in a regime change and uncharted environment; we don’t want or need to take unnecessary risks
More broadly, yield-curve control isn't unthinkable on a three- to ten-year view, but given the inflation issue, that is still a long way away. For credit investors, humility is required. There are many inflation drivers, we are in a regime change and uncharted environment; we don’t want or need to take unnecessary risks.
JV: That is not the consensus view. Unlike in previous crises, credit markets remained relatively orderly over 2022 despite periods of stress. HY and IG spreads widened gradually and, as yields go higher, there is increasing appetite from certain institutional investors who perhaps have been waiting for years to step in. As a result, demand has grown and many investors have started taking positions in duration and credit.
In contrast, we expect more inflation and rate rises this year. In addition, while investor appetite created a volatile environment, with spreads widening and tightening in turn in late 2022, at no point did we see a massive sell-off, freezing up of the market or a credit crisis. It may not happen, but as yields push higher, there is a risk, and some credit positionings may need to be unwound.