Fixed income managers hope for a bond/equity decoupling in 2023 and look for signs of a rally. Subtlety and selectivity are key, writes Piyasi Mitra.
As interest rates rise from historic lows and trigger portfolio changes, there are expectations that bonds will emerge as the most in-demand asset class in 2023. About 27% of fund managers worldwide are convinced that this is the case, according to a December Bank of America survey. The next most popular choices were stocks (25%); corporate bonds specifically (24%); and commodities (12%).
In an effort to identify the best fixed income opportunities, Funds Europe sought the views of market experts. Consider, for example, the increased yield on two-year US treasury notes, from just above 0.7% at the start of 2022 to about 4.5% towards the end. “It creates an incentive to stay invested in the market and provides a platform to seek attractive income even in low-risk, short-dated government bonds,” says Marc Seidner, chief investment officer of non-traditional strategies at fund manager Pimco.
Investors can then look to augment that yield – without taking on substantial credit or interest rate risk – by venturing into other high-quality areas of public fixed income markets, he says.
“Attractive sectors include municipal bonds [for US investors], US agency mortgage-backed securities, and the debt of banks and companies with strong investment grade credit ratings. Besides US Treasury Inflation-Protected Securities (TIPS) that shield from inflationary risks, structured credit – which in some cases has been trading at historically cheap levels – and short-dated credit, which may offer good all-in yields, look attractive.”
Subtlety is key
Adrian Owens, investment director of fixed income and currency-based funds at GAM Investments, sees relative value trades and some of the inflation-protection trades offered by bonds as promising return generators. “Avoid non-financial subordinated debt and credits in the bond market,” he warns. “Weak growth. Tighter monetary policy. Stubbornly high inflation. Not a great environment.”
What looks reasonable – though not necessarily exciting – are inflation-linked bonds such as the ten-year TIPS currently offering a real yield of 1.25%. “There is some inflation protection – but such bonds should do well even if the economy slows down [implying lower inflation].”
The US job openings and labour turnover survey reveals there are 1.7 job openings for every unemployed person, says Owens. “Wealth generation prospects can brighten up only with a pick-up in employment. US interest rates could peak at just under 5% by May-June, and only when the Fed [Federal Reserve] is ready to cut rates shall we witness a meaningful bond rally, unlikely to be a reality until end-2023.”
“Wealth generation prospects can brighten up only with a pick-up in employment. US interest rates could peak at just under 5% by May-June, and only when the Fed is ready to cut rates shall we witness a meaningful bond rally, unlikely to be a reality until end-2023.”
In the environment he envisages, investors benefit from greater selectivity rather than universality. For instance, Brazil took interest rates from just above 2% in 2021 to just below 14% recently, unlike slow-to-react central banks across developed markets.
Despite uncertainties, Owens remains hopeful of the government’s pragmatic approach, adding: “Things look interesting from a risk-reward point of view in Mexico too, offering opportunities through long bonds yielding above 9%.”
Subtlety is the key to making money in fixed income in 2023, says Owens. “It is between long in Sweden versus short in the UK – relative value trades – where the opportunities will lie in 2023 rather than outright directional long or short ones, with few exceptions.”
The import-heavy economy of Japan has also managed to bring inflation above target, that too with a weak, inflationary currency. “The beauty lies in the asymmetry. Not much is being priced by the market for high rates, so even if one is wrong on the rate, and short on those markets, the downsides are limited.”
“High-quality fixed income portfolios offering 6.5% of yield in the dollar on a risk-adjusted basis would make for an attractive proposition for investors in 2023.”
Grégoire Pesques, CIO of global fixed income at Amundi, says that fixed income portfolios with duration ranging from 10% to 20% or longer saw an “unusual positive correlation” between equity and fixed income last year. But following the “great repricing”, correlation levels are getting back to where improvement can be expected.
A significant portion of the fight against inflation has been fought, with duration being the key performance driver. “The risk-free rate – which was not free at all – suffered the most, but high-quality fixed income portfolios offering 6.5% of yield in the dollar on a risk-adjusted basis would make for an attractive proposition for investors in 2023,” says Pesques. “As volatility normalises, there should be not only a carry but also capital gain at some point.”
He adds that investors can expect more specific risks owing to lower correlation between market segments in times ahead.
A transitioning market
Raymond Sagayam, fixed income CIO for Pictet Asset Management, describes last year’s bond markets as a “bloodbath”, though the severity varied from market to market.
“The S&P was down 19% year to date, but nowhere close to longer-duration Treasury markets, gilt markets and longer-duration credit markets. There has been a complete rerating of the fixed income space driven by inflation at the same time as the broken fiscal taboo in a post-Covid arena,” he says.
Three factors – fiscal willingness, a non-transient and structurally embedded inflation, and tightening central bank policies – catalysed one of the most significant moves the bond market has witnessed in years.
“Two dimensions of corporate bonds – risk-free rates and credit spread – were felt acutely in full-maturity fixed income products and strategies,” says Sagayam. “Short-duration and money market funds managed fairly well last year because they haven’t had the same duration exposure, and that has been a more palatable move relative to their full maturity equivalents.”
Fixed income might behave differently in 2023, he believes. Last year, risky assets sold off due to inflation, and high interest and discount rates compromised both bond and equity prices. “A transitioning market, from inflation worries to growth concerns, will be crucial for fixed income to perform and decouple this behaviour in 2022,” he adds.
“Unlike equities which can rerate from expectations and earnings, a mild and acceptable recession could create a conducive market for government bonds.”
It’s expected that G10 central banks’ interest rate hiking will peak in Q1 or Q2. This could enable US Treasuries, gilts and G10 government bonds – which had a sharp rally in the last part of 2022 – to trade in the first half. According to Sagayam, a more normal inverse relationship between government bonds and equities is likely this year.
“Unlike equities which can rerate from expectations and earnings, a mild and acceptable recession could create a conducive market for government bonds.”
Emerging market central banks have proactively tamed inflation, he observes, adding that investors should be cautious on longer-dated corporate bond exposure, as credit cycles take a while to play out amidst the twin threats of rising funding costs and defaults over 2023-24. “Potentially, longer-dated sovereign debt will start looking more attractive in 2023 – whether rates plateau or start to come down quickly. Corporate credit is likely to lag the other markets. Over the near term, companies will feel the squeeze as earnings and margins come under pressure from rising interest rates, inflation and slowing demand.”
Against this backdrop, should a typical portfolio be 60:40 in favour of bonds? “One needs to be astute in optimal asset allocation. Short-duration funds could be an interesting area,” he says.
“Many yield curves – indicative of economic stress – remain inverted, but hope prevails as economies begin to normalise.
“Why take excessive duration exposure when you can get healthy yields in the front end in short-duration funds, both corporate and government, developed and emerging markets, while benefiting from a significant carry and roll-down strategy?”
Potential rally
The rate rise in 2022 led to a fall in bond prices, setting off a chain of events in corporate bonds that led to constant outflows from fixed income, says Edward Farley, head of European investment grade corporate bonds at PGIM Fixed Income. “However, inflation nearing a peak in Europe is indicative of a potential pivot followed by a sovereign bond rally – a positive sign for corporate bonds.”
Running with record post-Covid margins is an advantage for corporates now, notes Farley, thanks to a sharp rebound in demand helped by government stimulus packages.
The starting point in investment-grade corporate profitability is that most corporates are in good shape in terms of balance sheets and leverage. “As you go down the risk spectrum [within high yield corporate bonds], faults in earning will have a heavier impact on highly levered companies with significantly higher refinancing costs. Brace yourself for pitfalls when dipping your toes in riskier asset classes this year,” Farley says.
“Inflation nearing a peak in Europe is indicative of a potential pivot followed by a sovereign bond rally – a positive sign for corporate bonds.”
Iain Balkwill, partner at Reed Smith, hails the past couple of years as “record-breaking” for fixed income products tied to commercial real estate. “We witnessed the highest level of CMBS [commercial mortgage-backed securities] public issuance since the global financial crisis,” he says.
He points out, too, that London-based Starz Real Estate launched Europe’s first commercial real estate collateralised loan obligation (CRE CLO) backed by a pool of short-term, floating-rate loans secured against commercial properties in transition. This was “nothing short of a game-changer”.
Balkwill adds that 2022 was challenging for the asset class, with no more than a handful of CMBS deals and no further CRE CLO issuance. However, CRE fixed income products continue to perform well. “With the retraction of banks from funding commercial real estate, capital market money can now play a key role in filling the funding void to help fuel growth.”
Did Q3 of 2022 set the tone for some new year cheer? Figures from the European Fund and Asset Management Association show that net bond fund outflows in Europe and the US began to slow significantly at that time, mirroring an improved outlook for the asset class since the yield rise last year. As of now, bonds look ready to reclaim their role as a portfolio diversifier, shock-absorber and – hopefully – wealth generator, particularly if volatility causes pain for equities.
Emerging edge
If you think of emerging market debt across China, India, Brazil and elsewhere as precarious, then 2023 might have offered reasons to think again. While equities generated higher absolute returns over the past two decades in emerging markets, debt returns are about 40% higher when adjusted for volatility, according to research by fund manager Payden & Rygel.
Also in emerging markets, fund manager PineBridge Investments expects Asia investment grade bonds – the biggest segment of the Asian bond market – to witness strong interest due to reasonable yields and high credit quality. Compelling risk-adjusted returns, with higher yield and shorter duration than similar high-quality bonds in other regions, make the asset class a strong diversifier for global investors, the firm said in a report. Besides which, some local currency markets – especially Singapore and Thailand – are likely to perform better next year.
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