James Vokins and Chris Higham from our investment-grade credit team discuss opportunities and risks in a higher rates world.

Read this article to understand:

  • Key factors contributing to uncertainty in global credit markets  
  • What makes investment-grade credit attractive on a risk-adjusted basis 
  • The challenges caused by quantitative tightening

After more than a decade of bond buying by major central banks, which bolstered sentiment and supressed yields, the impact of inflation and rapid interest-rate increases are reverberating through financial markets. The disappearance of cheap borrowing has already taken down high-profile names and prompted investors to question what will happen when central banks trim their balance sheets with greater vigour (see Fragilities exposed as cheap money disappears).1

Some trading strategies that proved successful in the past are unlikely to be so in the future

In this higher inflation, higher rates world, some trading strategies that proved successful in the past are unlikely to be so in the future. In this Q&A, James Vokins (JV), global head of investment-grade credit, and senior portfolio manager Chris Higham (CH) discuss how they are positioning for the new market regime.

Yields have moved significantly – how does IG shape up against other risk assets?

JV: At the beginning of 2023, we were constructive on investment grade (IG) relative to other fixed-income asset classes. In an economic slowdown, high-quality fundamentals should outperform low quality. The spread premium for IG looked attractive and yields were as high as they have been for a decade.

While we were conscious higher yields were also available in government bonds, we did not believe we were at the end of the cycle yet and still felt there were better risk-adjusted returns available in IG. And, other than selective opportunities, the yield pick-up in high yield (HY) relative to IG was not compensation enough for the credit and default risk. We have become accustomed to receiving two-to-three times more yield from owning HY than IG. In this case, an investor would be getting less than double.

We were not expecting it to be a strong year for spread tightening because of vulnerabilities in the market and further rate hikes. Our structural view is for spreads to be wider over the longer term, but heightened  volatility is likely to produce some short-term opportunities. Equally higher yields are offering more of a cushion against volatility. In other words, even in a modest spread widening environment, positive total returns can be delivered. IG has more duration than HY, so there is a natural hedge if recession fears accelerate and a flight to safety picks up.

At a sector level, where do you see the greatest opportunities and risks?

CH: We are cautious of the impending slowdown instigated by central bank tightening. We think it’s likely to prove challenging for most sectors. There are, however, non-cyclical areas we like including technology, media and telecoms (TMT) and utilities.

In an environment where growth is slowing and there is the potential for recession, the focus is on not owning the things that go wrong: not holding Credit Suisse Additional Tier 1 bonds (AT1s, a form of contingent convertible) or debt issued by SVB Bank, and so on. For credit investors, avoiding the losers is always more significant than trying to pick winners, but even more so now.

The big risk episode of the year has been in financials

In January, we would have said financials were likely to benefit from interest-rate rises. Certainly, from an earnings perspective, we have seen US money centre banks reporting strong earnings on the back of them. But, of course, the big risk episode of the year has been in financials. 

JV: Banks make up about 25 to 30 per cent of IG and a smaller part of HY. In our view, the issues with financials are contained within a few US regional banks rather than the large money centre institutions we own.

SVB failed, and now First Republic Bank has been taken over. Needless to say, these are significant events, but it’s worth noting the overall exposure in the debt markets of these credits, and regional banks in general, is small. SVB only made up around 0.03 per cent of the global IG benchmark while First Republic only had subordinated bonds in HY. We do not expect that to be the end of the matter. There's potential for more ripple effects throughout the US regional banking sector.

We do not see Credit Suisse as indicative of another long-term systemic issue

The situation with Credit Suisse was triggered by what happened at SVB, although Credit Suisse had well-recognised problems. It was losing money every quarter and giving earnings warnings repeatedly. While it is significant to witness a global systemically important bank fall over, our view is that there is slightly better capital and liquidity strength in European banks. We are comfortable with our modest overweight and do not see Credit Suisse as indicative of another long-term systemic issue.

In terms of losers, real estate has been the worst-performing sector. It is the area of most concern both directly but also for those exposed to the sector, whether they are life insurance businesses or banks. Clearly there are ongoing structural pressures in the retail and office markets and questions over residential property too.

How have your allocations changed from a year ago?

CH: We are overweight higher-quality credits. Within financials, we started the year with a large overweight, then went into February modestly overweight. That hurt us initially, but since then performance has come back through adding higher-quality names.

JV: We reduced HY exposure by trimming a riskier component in subordinated financials, part of our strategy of reducing overall banking exposure. Fortunately, most of that was completed prior to the issues that emerged in March. We have also increased exposure to safer assets – high quality AA- and single A-rated bonds, and more Treasuries.

We must be more attuned to specific idiosyncratic stories that can still generate outperformance regardless of market direction

We have concentrated the global IG portfolio into fewer holdings and are trying to differentiate winners and avoid losers rather than trying to make excess returns from dialling up beta. That was the way to trade previously; in the last decade, whoever had most carry generated the most excess return. Conditions are changing and that strategy is unlikely to work as well in future.

It means we must be more attuned to specific idiosyncratic stories that do not correlate so much to beta but can still generate outperformance regardless of market direction. It is all increasingly about stock selection, name concentration and conviction.

What's changed on the inflation and rates outlook?

JV: Higher interest rates have exposed vulnerabilities, making the landscape more challenging for central banks to navigate. We believe they will target inflation over financial stability in the longer term, but there is more to do in the short-to-medium term to ensure the smooth running of financial markets.

The banking issues in March led the rates curve to move lower as everyone priced in a stress scenario, bringing forward the likelihood of further rate cuts and lower growth and inflation. The consensus has shifted to a more cautious stance and interest-rate cuts towards the end of this year. It is clearly difficult to try and pin down an end-of-year view, but our base case is that this is still too soon for cuts. Longer term, we think there are structural forces at play that may ensure inflation is sticky and rates will end up modestly higher from here, closer to “normalised” levels within fixed income.

This is still the early stage of a new dawn for fixed income and markets in a higher inflation, higher rates world

Regional differences have also intensified. At the beginning of the year, market moves were close to the same order of magnitude in Europe and the US. It now feels as if the US is a little ahead, with inflation starting to soften, or some cracks appearing in certain sectors. In Europe, inflation is still quite strong and there may be more to do by central banks. These nuances are making things more interesting from a cross-currency perspective.

Broadly, our views on inflation and growth are constant reminders of the stresses in the market. This is still the early stage of a new dawn for fixed income and markets in a higher inflation, higher rates world. We do not want to get complacent about assuming things will go back to where they were.

Are you concerned about the step-up in overall indebtedness?

CH: We spend more time on this than anything else, particularly what it means now the regime that put downward pressure on yields has begun reversing. The cost of money globally has quickly gone from around zero to five per cent, which will take a while to work through. In the process, we will find out exactly who has been doing the things they should have been doing and vice versa.

Markets are grappling with major questions and that is why there is a struggle to price assets. Inflation is close to a 50-year high, there are big questions about demographics and structural changes in labour markets, and we are grappling with the green transition and geopolitics. All these things play a part in what is happening and why we think inflation is likely to persist.

Inflation is a comparatively easy way out of the high-debt scenario

Inflation is a comparatively easy way out of the high-debt scenario, and it’s one we have been contemplating for three or four years. That takes us back to when we first put inflation protection into our funds – at a time when it was not being priced more widely. We are mindful of the turning points and likelihood things may be volatile while the issues work through.

JV: But the issues are hard to pin down and monetise. Timing is key. There are ways we can protect downside longer term while still benefiting from tactical positioning, but, speaking broadly, investment horizons may be shorter term. If you constantly run the same long-term view and never change, you run the risk of missing opportunities. We must always come back to solid ground, as there is a lot of debt out there. We need to be mindful exactly where it is – in governments, corporates and households.

The Fed is trying to improve liquidity in the Treasury market by expanding the number of market makers. Could this have any knock-on effects?

CH: At the start of 2022, we were more concerned about quantitative tightening (QT – central bank balance sheet reduction) than rates going up. Central banks had never experienced these situations before, so it was hard to know what the impact was going to be.

Liquidity can come and go quickly, and we need to be sure we have a chair to sit on when the music stops. Things have changed a lot since the financial crisis – risks have changed. Nevertheless, we are more confident now about the health of the financial system: leverage is not at levels seen in 2006, 2007 and 2008.

Changing the list of market makers will not significantly alter the situation. Each new player with some balance sheet will help marginally, but it is unlikely to make a difference overall unless there is a significant change in regulations. 

The US believes in free markets and people being able to lose money, make money and lose it again. That is why it feels as if they lurch from one crisis to the next. In Europe, there is more oversight and intervention, and you tend not to see the same kind of excesses.

There is more oversight and intervention in Europe than in the US

JV: That brings us to an interesting question about what we could see on the regulatory side after the SVB failure. That situation is fairly contained, given its deposit base was quite monoline and there are few business models like it. That said, there needs to be better regulation around the speed at which deposits can leave a bank in a world where so much banking activity is online. Bank stress tests have shored up capital, but not so much liquidity. There is more liquidity regulation needed, which will come at a cost to earnings.

No bank wants to be losing deposits in this kind of scenario, so there is likely to be greater competition for deposits. It is interesting to see how much deposit flight came from SVB into the big banks like Bank of America and JP Morgan, then was reinvested in money market funds by savers looking for higher rates. The average deposit rate offered by the larger banks is around one per cent in the US against about five per cent in money market funds: you can obviously get a significant uptick from low-risk money market savings accounts.

Will recent market turbulence put QT on hold?

JV: Central banks acted quickly to address financial stability and there may be more to do in the short term. Longer term, they still have a job to do on inflation and unwinding their balance sheets, which I think they will continue to do, but that is just not the focus for now. I expect it back in the coming months. We have the US debt ceiling issue coming up in the summer as well.

QT is likely to be part of the toolbox and something central banks wish to continue with, providing markets allow it

Beyond that, QT is likely to be part of the toolbox and something central banks wish to continue with, providing markets allow it. The impact is yet to come through. We’ve never experienced QT to the extent we are likely to in the next phase, which adds to the reasons to be cautious.

At the moment, the UK is the only country where corporate bond QT is ongoing (see Figure 1). The process is going better than we anticipated so far.

Figure 1: Unwinding UK corporate bond purchase scheme (£ billions)

Unwinding UK corporate bond purchase scheme

Source: Bank of England, April 28, 20232

Related views

Important information


Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. Some data shown are hypothetical or projected and may not come to pass as stated due to changes in market conditions and are not guarantees of future outcomes. This material is not a recommendation to sell or purchase any investment.

The information contained herein is for general guidance only. It is the responsibility of any person or persons in possession of this information to inform themselves of, and to observe, all applicable laws and regulations of any relevant jurisdiction. The information contained herein does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it would be unlawful to make such offer or solicitation.

In Europe, this document is issued by Aviva Investors Luxembourg S.A. Registered Office: 2 rue du Fort Bourbon, 1st Floor, 1249 Luxembourg. Supervised by Commission de Surveillance du Secteur Financier. An Aviva company. In the UK, this document is by Aviva Investors Global Services Limited. Registered in England No. 1151805. Registered Office: 80 Fenchurch Street, London, EC3M 4AE. Authorised and regulated by the Financial Conduct Authority. Firm Reference No. 119178. In Switzerland, this document is issued by Aviva Investors Schweiz GmbH.

In Singapore, this material is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited (AIAPL) for distribution to institutional investors only. Please note that AIAPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIAPL in respect of any matters arising from, or in connection with, this material. AIAPL, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 138 Market Street, #05-01 CapitaGreen, Singapore 048946.

In Australia, this material is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd (AIPPL) for distribution to wholesale investors only. Please note that AIPPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIPPL in respect of any matters arising from, or in connection with, this material. AIPPL, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business address: Level 27, 101 Collins Street, Melbourne, VIC 3000, Australia.

The name “Aviva Investors” as used in this material refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom.

Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is based within the North American region of the global organization of affiliated asset management businesses operating under the Aviva Investors name. AIC is registered with the Ontario Securities Commission as a commodity trading manager, exempt market dealer, portfolio manager and investment fund manager. AIC is also registered as an exempt market dealer and portfolio manager in each province of Canada and may also be registered as an investment fund manager in certain other applicable provinces.

Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) registered with the Commodity Futures Trading Commission (“CFTC”) and is a member of the National Futures Association (“NFA”). AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606.