The co-managers of the Aviva Investors Strategic Bond strategy give their views on the outlook for credit markets following the worst first-half in at least 40 years.
Read this article to understand:
- Why credit markets are likely to stay volatile in the near term
- Why investors should remain patient, and focus on economic data
- Why investment-grade debt looks a safer bet than high yield
For more than four decades, developed market bonds delivered stellar returns to investors. Subdued inflation and declining economic growth encouraged central banks to steadily lower interest rates, while yields were further constrained by a global savings glut.
Suddenly, however, the picture is very different. Markets suffered their worst six months in at least 40 years in the first half of 2022, with the Global Aggregate Index returning -14.1 per cent. Although sirens proclaiming the death of the bull market are not new, they have reached fever pitch with central banks expected to tighten policy aggressively as they look to douse scorching inflation.
We spoke to the co-managers of the Aviva Investors Strategic Bond strategy, Chris Higham (CH) and James Vokins (JV), to find out how they have been steering their portfolio through a testing period and for their thoughts on where bonds might be heading next.
Is this the start of a long-term bear market?
JV: It is too early to call. The bull run wasn’t defined until ten years into it, so we aren’t going to know whether this is the start of a long-awaited unwind for a few more years yet.
Bond markets have been helped for years by several structural factors, such as demographics and globalisation, that have kept growth and inflation sustainably low. These trends have enabled monetary policy to become ever looser. Although this caused desirable financial outcomes, it has led to less desirable economic consequences, such as widening inequality and excess leverage.
There are probably a few more structural boxes to tick before you can define the current situation as a paradigm shift. However, there are reasons to believe inflation might not be anywhere near as supportive in future. The same goes for monetary policy. With more debt in the system, there is the potential for instability, even if central banks do everything in their power to prevent another global financial crisis.
On the other hand, markets have fallen a long way and priced in a lot of monetary tightening. Central banks, if they hike rates as much as market participants expect, may succeed in reining in inflation without plunging economies into recession. Should that happen, global investment grade yields of 4.4 per cent, and high yield yields of almost nine per cent, could start to look attractive. After all, demographics, liability matching, and other trends remain supportive for fixed income. I would be hesitant to suggest we are in a long-term bear market just yet.
CH: Inflation has been the key and will remain so. Even before the pandemic, we were anticipating a more inflationary environment given we seemed to be entering a new era, with budget deficits widening and the efficacy of monetary policy called into question. Obviously, we have had some significant external shocks since then, such as the pandemic and war in Ukraine.
Central banks are trying to prevent a recession but at the same time curtail demand
People are struggling to disentangle the various effects and work out the extent to which inflationary pressures are here to stay or likely to subside. Central banks are trying to prevent a recession but at the same time curtail demand to the point where demand and a new level of supply reach equilibrium. An already difficult task is made that much harder by the fact they cannot do much about supply-side shocks.
Having let inflation get out of control, central banks have a credibility problem. The real worry for them is if supply-side problems persist and inflation stays high as the economy goes into recession. Although Federal Reserve chairman Jerome Powell recently described its inflation fight as “unconditional”, it is unclear how it would behave if faced with such a scenario.
If inflation is still high next year and growth is marginally negative, there is going to be a limit to what central banks can do. Markets are pricing in cuts from central banks in 15 months’ time but if inflation remains high they are unlikely to be able to provide that support.
Has the huge sell-off in the first half created a buying opportunity?
CH: It depends on your holding period. The yields now on offer present a far more attractive entry point than was available at the start of the year. But while we are mindful of those valuations, there is still an awful lot of uncertainty. It is very early days in the interest rate hiking and quantitative tightening cycle. In the short-term, we think we are in for higher inflation and more rate hikes, while further ahead we could be heading into recession. Against this backdrop, patience is likely to be rewarded.
To get more comfortable taking risk, we need to see inflation coming down
JV: To get more comfortable taking risk, we need to see inflation coming down. And this could be triggered by base effects, declining commodity prices, or because of the restrictive policy the Fed and others are embarking upon.
Although credit spreads have widened significantly, inflation is still a long way away from being priced into rates markets. Furthermore, we do not think it has peaked yet and see more surprises to the upside. Even if it is just for another month or two, those numbers are still very high relative to history. Given that, the risk is skewed towards spreads and yields moving higher in the near term.
How have you been navigating such tricky market conditions?
JV: At the start of the year, with inflation starting to pick up meaningfully, we expected monetary policy would need to be tightened – potentially aggressively. That meant credit spreads and yields would likely need to find a new higher level, having been artificially supported for too long.
As a result, the duration of our portfolio was two years less than its benchmark, which was as short as it has ever been. In addition, ten per cent of the strategy was allocated to protecting against inflation via break-evens in Europe and the US.
We have been surprised by the extent to which the war has exacerbated inflationary pressures
We have been surprised by the extent to which the war has exacerbated inflationary pressures, and just how fragile risk assets have been without the support of central banks. The hunt for safety and need to raise cash has led to some indiscriminate selling within credit markets, a trend that has been exacerbated by the growing presence of exchange-traded strategies.
CH: Telecoms, banks and financials are sectors you might have expected to be more defensive or benefit from a rising rate environment. But investors’ need for liquidity means they have underperformed because they contain more liquid bonds and many of these companies were still issuing debt.
The same goes for short-duration bonds. While we were right to be short duration, they have not performed as well as we hoped because investors have tended to look through their portfolio and pick out bonds that are the least underwater.
Although we have sold our inflation hedges, the strategy is still positioned quite defensively as we think the outlook for inflation and monetary policy will continue to drive markets. In terms of the latter, the withdrawal of policy support is still in its infancy.
We expect cyclical sectors of the market will struggle as growth slows and central banks hike rates
The strategy's duration is still significantly less than its benchmark, albeit by less than at the start of the year (at one and a half years). We are also underweight more cyclical sectors of the market, such as industrials and consumer discretionary companies, which we expect will struggle as growth slows and central banks hike rates. We are also underweight high-yield debt and retain a sizeable cash balance.
JV: On a more positive note, some of the technical behavioural biases already mentioned are presenting interesting investment opportunities. For instance, the need for liquidity is part of the reason why credit curves have flattened so much. This has meant the rise in yields at the short end has been in line with much further out along the curve. While the rising risk of recession helps explain some of this flattening, it is hard to rationalise in its entirety.
We have been acquiring investment-grade bonds with a duration of around five years as they look comparatively attractive. Having quadrupled in the space of a year, five-year bonds now offer similar yields to debt with much longer maturities.
With less liquidity in the system, there should be pressure on long-duration fixed income. While some of this has been priced in, the front end has taken anticipated rate hikes into account far more. For this reason, we expect steeper yield curves and more dispersion across sectors.
We expect credits bought by the ECB to underperform non-eligible corporate debt
We are also looking to take advantage of the unwinding of the European Central Bank’s (ECB) corporate bond purchase programme. The central bank has been buying corporate bonds since 2015 and in 2020 launched a pandemic emergency purchase programme to support companies across the continent and prevent an expected wave of defaults.
We expect credits bought by the ECB to underperform non-eligible corporate debt. So far, there has been little evidence of it, but we think it is inevitable as the programme is unwound.
High yield has held up better than might have been expected. Why is this and can you explain why you are underweight this asset class?
JV: There has been a lot of technical pressure on investment-grade debt as it tends to be more liquid, linked to rates markets and have a longer duration. In some cases, investors have been trying to get ahead of the market, aware there was quite a lot of supply in the pipeline.
By contrast, we have not seen much high-yield issuance. Appetite has been subdued and issuers have been willing to wait for better conditions to issue. Initially, that was widely believed to be a positive technical factor as it meant less supply hitting the market. However, it is steadily becoming more of a negative consideration. As the overhang gets bigger, the uncertainty around where high-yield companies will be able to strategy themselves grows.
Investment-grade bonds are comparatively sensitive to changes in interest rates
Investment-grade bonds are also comparatively sensitive to changes in interest rates, whereas high yield is driven more by the credit element. And although the market is pricing in aggressive hikes in interest rates (hurting investment-grade debt), it has so far not priced in a recession, preventing the spread on high-yield debt from widening dramatically.
While our central case is not a recession, the risks around this forecast are rising and we now think there is a 30 to 40 per cent chance of an economic downturn over the next year or so, which is meaningful.
The risk of recession has not really crept in to corporate fundamentals in a meaningful way. However, we have started to see some concerning updates from companies around labour and commodities costs, and some banks have begun to warn about bad debt.
In the event of a recession, high yield would almost certainly underperform investment grade – though both would clearly suffer. Part of the reason is central banks may take their foot off the gas, which would help limit losses in investment-grade debt, but the prospect of rising defaults would dominate high-yield markets.
CH: Although markets have moved a long way, and spreads have moved a lot higher, there is still some distance to go before the market starts pricing in a recession. It is difficult to compare the relative value of high yield to investment grade when we’ve never really been in this kind of investment environment before.
There is still some distance to go before the market starts pricing in a recession
That caveat aside, when you question whether you are getting compensated in high yield for the risk of recession and rising defaults, we would say you are not. Spreads would need to be a couple of hundred basis points higher for that to be the case.
JV: Having said all this, high yield is offering very good historic returns. Since credit is a carry asset class, it is hard for us to be materially short. If you are short of an asset that is yielding as much as nine per cent, you are obviously paying nine per cent of your portfolio to run that position. Viewed another way, spreads and yields need to move a lot higher for you to lose money when yields are this high.
When historically buying at these levels, the forward return is often double digits. But we are no longer in the volatility suppressed era that followed the financial crisis and cycles are now likely to be shorter. As active managers with a strategic asset allocation strategy, we are looking to exploit these shorter business cycles and invest where we see greatest relative potential.
A lot of companies took advantage of low interest rates to issue debt in recent years, in many cases to buy back equity. For example, US non-financial corporate debt has risen to 50 per cent of GDP from 40 per cent a decade ago, and 30 per cent at the start of the 1980s. To what extent are debt levels a concern?
CH: The fundamental point is company balance sheets are as good as they have ever been. Whether that is debt to underlying earnings or interest coverage ratios, the metrics are strong, which gives you confidence in terms of the risk of defaults.
JV: Debt-to-GDP has risen quite sharply, but then again corporate earnings have risen relative to GDP. That is not to deny there is a lot of debt outstanding but, without wishing to sound complacent, earnings would need to deteriorate sharply before this became a problem.
There is little prospect of companies issuing debt to buy back equity in this environment
CH: Although share prices are cheaper, there is little prospect of companies issuing debt to buy back equity in this environment as companies can no longer take advantage of cheap borrowing. Whereas 18 months ago it would have cost around two per cent, now they are paying five per cent.
Every deal now is for general corporate purposes. It would be surprising to see a company borrowing money to buy back shares. It is not a great use of proceeds. With investors becoming more selective with new issues, there would be little appetite for that.
In summary, what are the key factors investors should be considering at present?
JV: While entry levels are becoming more attractive, especially for investors prepared to take a long-term view and able to withstand short-term pain, risk and the likely dispersion of returns has increased substantially. So long as this continues, investors will continue to demand greater compensation.
Inflation, commodity prices and the labour market need to be monitored closely
With soaring inflation limiting central banks’ ability to come to the rescue of financial markets by loosening policy, macroeconomic indicators arguably assume greater importance than we have become accustomed to in recent times. Inflation, commodity prices and the labour market need to be monitored closely.
Until we see clearer signs inflationary pressures may be subsiding, we expect markets will continue to test central banks’ determination to get ahead of events.