Is fixed income still broken?
I recently took part in a panel organised by investment profession information, thought leadership and education experts, Hubbis, to discuss “Fixed Income & Credit – Opportunities and Challenges for the Year Ahead” -
A Zoom recording is available for anyone wishing to re-watch the event.[1]
The background to the panel, as summarised by the good people at Hubbis noted-
“As we turn the page into 2023, many investors are still reeling from the speed and scale of rate hikes across the developed world in 2022. But with all that comes some positives, as coupons as well as spreads offer private clients yields that even in late 2021, they might not have imagined seeing for many years ahead and had not seen since before the global financial crisis. But now rates are much higher, how do private clients play the world of fixed income and credit? “
Fellow panellists included Nomura’s Gareth Nicholson, Allspring’s Henrietta Pacquement and Standard Chartered’s Abhilash Narayan.
All made several excellent points, Gareth providing a very informed broad overview of fixed income and Henrietta’s contributions being quite exceptional in my view.
Gareth set the tone by declaring that “Bonds are back and we’re quite excited.”
Henrietta reinforced this by explaining that the pain taken by bond markets last year has left fixed income pricing in a much better place to start 2023. “Income is back and investors no longer need to stretch down the credit spectrum or into less liquid assets to get yield to avoid the iceberg of negative yielding debt that at one stage peaked at USD18 trillion of paper and we are looking at over 5% in the USD and GBP investment grade credit and over 4% in EUR investment grade credit. With rather flat all-in yield curves as well. All in all, those are much healthier levels to start the year for investors. Negative momentum in sovereign performance is abating though rates volatility remains elevated. From a fundamental perspective, inflation is still hot, even if it is trending in the right direction and growth signals are going south. That gives us overall a more neutral signal on rates at this point, but not a slam dunk either way as yet.”
At MBMG we have concerns about inflationary aspects of China’s re-opening but Henrietta made the excellent point that China’s role as the ‘factory for the world’ could see re-opening unleash global disinflationary pressures, although ultimately she echoed MBMG’s view of inflationary cross currents ahead for some time “In reality, there are more push and pull forces on the inflation side begin to play out over the course of the year ahead.” Positive potential surprises include mild winter in Europe, the record speed at which Germany has constructed LNG terminals storage capacity and the weakening Dollar – “One should not underestimate how much of a wrecking ball the strong dollar was last year putting non-USD economies at a real disadvantage given many commodities are priced in USD, forcing flows into the market as well as forcing global central banks to be more aggressive in their hiking cycle than they may have wanted.”
On the flip side, Henrietta’s concerns about inflation risks included relatively tight labour markets, China re-opening stimuli, ongoing military/geopolitical conflicts. Any signs of such inflationary pressures could have an adverse effect on trigger happy central banks.”
My view remains that the inflation excuse will only last for so long now that it has served the purpose of providing cover for the US Federal Reserve to (in its view) ‘normalise rates’ as it has wanted to do for some years -
“Inflation has been a great cover story as the Fed wanted rates back above 5% since 2012, so that when they cut them when required.
That is their version of normal, assuming historical exceptions are anomalies, so we see inflation really just as an excuse…..If you look at the shape of the curve now, rates are telling us that we are going to be getting booming growth for the next 30 years.
Markets were wrong before this shift, and I think they are wrong about the idea of a 30-year boom as well.
This creates a massive opportunity, because we see from history that the bond market players are capable of getting it very wrong, and we think they are getting it very wrong right now.”
As a consequence, we see downside risk in US Dollar that might, or might not generate a nasty surprise for the non-Dollar clients with dollar exposures, reinforcing our preference for the taking an interest rate view (and a view that markets are too bullish on 30 years growth prospects), through the long end of the treasury curve, while looking to avoid credit risk, which just doesn’t, in our view, offer adequate compensation.
Broadly the panel agreed that US high yield is seriously underestimating the potential for rising defaults, but Gareth in particular expects spreads to widen sufficiently to offer much better value by the second half of the year.
While some panellists had concern about developed economies being able to service elevated levels of debt at increased interest rates, I noted that the ‘crisis’ of 2020 had seen policymakers achieve greater understanding of more empirical approaches to understanding sovereign debt, citing the example of Japanese Government Bonds (“JGBs”)-
“In the JGB auctions this year, there is a huge story. Nobody was turning up to buy JGBs, and yet the market continued to function perfectly adequately even with Bank of Japan and the finance ministry as at times the only buyer of their own bonds.
You only really have a government debt crisis if you issue in a foreign currency, which can result in inflation, possibly hyperinflation.
If you’re Japan, and you’re just issuing in Yen, you haven’t really got that constraint, as long as you have a functioning central bank and a functioning ministry of finance.
The UK found out in the last few months that it does not have a functioning central bank; it has a totally maverick and bizarre one that recently seemed quite determined to undermine the government.
However, all in all, any idea of a major economy government debt crisis is not credible at all.”
One point of disagreement was in relation to investing in private debt (i.e. not listed company) debt.
In my view, the lack of significant capital appreciation potential means that even though interest income or coupons are above average, this is, on a total return basis, a low return, high risk sector-
“Private debt means not knowing what you’re investing in and not having access to price disclosure. As long as it doesn’t go wrong, then it’s a great way of disguising/neutralising volatility, but of course, when it does go wrong, it can go from hero to zero (often literally) in the blink of an eye.
The lack of pricing disclosure probably means that this is a bad time to buy and a good time to sell private debt.
We are running for the hills and avoiding private credit right now.
By the time you’re into that constructive renegotiation, it’s a bit of a mess anyway.
To quote a friend of mine, this idea that you have to have some high yield exposure and that you have to choose between leveraged loans and private credit, it seems like the choice between rolling around in horse dung or rolling around in cow dung.
Actually, you don’t need to be in that part of the market, you can get perfectly adequate, much more attractive, risk adjusted returns in treasury markets today.
The private credit story is over and private credit today is probably fully priced and, in some cases, overpriced.”
Henrietta also had some sympathy for this viewpoint- “Public markets are again attractive for fixed income and the intense drive for private credit exposures was largely pushed by the financial repression from the central banks. When you buy private paper, however, you need more yield to compensate for the liquidity of that area of the market. In general, I think it is to be handled with care, particularly as we see the economic environment will become more challenging over the course of 2023.”
The panel broadly agreed that once consequence of this is that the 60/40 allocation model (60% equities, 40% bonds) will come “roaring back with a vengeance”, although I warned that FX volatility that could remain elevated in 2023, meaning that investors will need to be paid enough in USD to offset the FX risk.
The panel also saw less reasons to use leverage in this environment, although my voice was again probably the most extreme-
“Leverage should generally play no role whatsoever in fixed income portfolios in any environment. There are exceptional situations at both macro and individual client levels but leveraging credit portfolios is like playing Russian Roulette. Leverage is basically saying that you have a very high conviction view that prices and values are going to be higher in a certain period of time than they are today, and even though we are all positive about the bond market, there is real uncertainty ahead.”
I was, however, far more upbeat about the potential for structure products than I have been for many years, in both debt and equity.”
While Abhilash sees China as being the policy area in the year ahead, for me it’s still all about the Fed base rate-
“They seem determined to get rates above 5%, keep them there for a while, all just so they have room to cut them back to 3% to cure the recession that they end up creating, which is a logic I don’t fully understand!
Another worry is US geopolitical policy, which is going to have a massive impact on the rest of the world.
In short, US policymakers are the biggest threat to portfolios in 2023 and beyond despite the sector’s opportunities which mean that selecting fixed income to add to your portfolio right now is akin to shooting fish in a barrel.”
Henrietta echoed the opportunities but was more circumspect about the timing – “In short, perhaps a year of two halves, and definitely a lot of opportunity to add fixed income to portfolios over the course of the year”.
MBMG Investment Advisory is licensed by the Securities and Exchange Commission of Thailand as an Investment Advisor under licence number Dor 06-0055-21.
For more information and to speak with our advisors, please contact us at info@mbmg-investment.com or call on +66 2 665 2534.
About the Author:
Paul Gambles is licensed by the SEC as both a Securities Fundamental Investment Analyst and an Investment planner.
Disclaimers:
1. While every effort has been made to ensure that the information contained herein is correct, MBMG Investment Advisory cannot be held responsible for any errors that may occur. The views of the contributors may not necessarily reflect the house view of MBMG Investment Advisory. Views and opinions expressed herein may change with market conditions and should not be used in isolation.
2. Please ensure you understand the nature of the products, return conditions and risks before making any investment decision.
3. An investment is not a deposit, it carries investment risk. Investors are encouraged to make an investment only when investing in such an asset corresponds with their own objectives and only after they have acknowledge all risks and have been informed that the return may be more or less than the initial sum.
[1] https://us02web.zoom.us/webinar/register/rec/WN_OJGWjDArSn2LJSOQPas3hw