Fixed income opportunities

One reason for caution is that while in some respects inflation appears to be moderating, it’s unlikely to fall as fast as central bankers expected a year ago. Which is why it’s premature to draw the conclusion that the war against inflation has been won. 

The risk is that central banks now maintain rates higher for longer. This, though, is unlikely to be a mirror of the lower-for-longer regime that persisted for roughly a decade following the global financial crisis that began in 2008 – though it will still take at least an extended period of uncomfortably high rates before inflation edges back towards central banks’ original target ranges (broadly 2 per cent across much of the developed world). 

For now though, markets seem to be anticipating an interest rate overshoot. US Federal Reserve Chairman Jerome Powell has recently been referring positively to his uber-hawkish predecessor Paul Volcker, best known for finally overcoming the US’s last big inflationary episode of the late 1970s and early 80s. This suggests an increasing tilt towards erring on the side of excessive tightening rather than watering down policy measures before they’ve fully subdued inflation. Indeed, 75 basis point rate increases at policy meetings seems to have become the new normal.

Fig. 1 - Quick up, slow down

Implied forward Fed funds rate, %

As a result, the markets are pricing in a peak in Fed funds of some 5 per cent during the first half of 2023, followed soon after by a return to monetary easing (see Fig. 1). This seems an overly optimistic reading of how fast inflation is likely to be driven back to the central bank’s target in light of persistent price pressures and a tight labour market. 

But whatever happens once the interest rate cycle peaks – whether rates plateau or the Fed quickly starts easing again – the very fact that monetary tightening has run its course is a strong signal for the markets. At that point, longer-dated bonds are likely to start to look attractive, irrespective of whether the Fed starts cutting soon after or allows rates to plateau at that higher level for some time.

Fig. 2 - Sovereign attractions

Local 10-year real government bond yields*, %

Today, longer-dated bond yields are attractive but volatility means investing in such securities is a potential hazard. So short-duration, high quality bonds are our preference for now. Even corporate bonds with short maturities are offering attractive opportunities for investors – risks (like a sudden economic slowdown) are being balanced by unusually attractive rewards over this very short time horizon. And as we push into 2023 and clarity emerges on inflation, investors will be able to move further along the curve and particularly into government securities, where real bond yields already look attractive (see Fig. 2).

Where, then, does that leave investors? 

Historically, this stage of the economic cycle, where interest rates are still rising but inflation shows signs of stabilising, tends to favour developed country sovereign debt in the first instance. The appeal of such bonds will depend on real yields, the relative valuation of the relevant currency and the degree to which the market might be vulnerable to capital flight.

It can be argued that US Treasury bond yields are fast reaching the point where they are fairly priced, especially in the front end of the curve. Other G10 central banks are lagging the Fed in their tightening cycles, but by and large their domestic bond markets should also arrive at fair value in the coming quarters.

What’s more, investors have a significant margin of safety. Yields have risen enough that investors can take significant further drops in bond prices and still generate positive inflation-adjusted returns (see Fig. 3). 

Fig. 3 - Margin of safety

Breakeven yields relative to yield to maturity by fixed income class*, %

So far, equity investors remain relatively sanguine, even as credit markets have struggled. Yes, the S&P 500 has lost 19 per cent in the year-to-date, but this magnitude of decline is hardly symptomatic of severe market stress. 

In part, this relative stability in equities reflects the fact that corporate profits and margins have, so far, held up well. But that is unlikely to last long. Companies are vulnerable to a combination of inflation, rising costs of debt, weakening growth and a stronger dollar – which is bound to weigh on earnings. 

As an aside, it’s worth noting that one other reason for the equity market’s orderliness is that many equity asset allocators entered 2022 with low or no leverage and have since actively hedged away or sold their equity holdings to avoid being wrong-footed by a leverage-triggered selloff. Which is why equity volatility has been contained relative to past selloffs – but it doesn’t mean it is immune to further upheavals. And that’s a concern for credit investors, too. As companies face increasingly difficult conditions, equity and credit markets tend to move in lockstep: credit and stock market crises tend to coincide.

In the past few decades, equity investors have been able to rely on the so-called ‘central bank put’ to bail them out of difficult times. But in the face of persistent inflation, that insurance policy is likely to have expired.

Meanwhile, most people aren’t yet focused on the flood of corporate debt that will need to be refinanced over the next few years – after all, it won’t start to ramp up until 2024. But that ignores the fact that corporate treasurers will try to get their funding done well ahead of time, especially if they are concerned that this supply will cause spreads, and therefore borrowing costs, to increase further.

Just as investors shouldn’t read too much into how stable corporate earnings and margins have been, they also shouldn’t be lulled by very low corporate default rates. These tend to lag developments in credit spreads by six to 12 months (see Fig. 4). And credit spreads have been rising. All of which is to say prepare for some tough times ahead in the credit market, even if there are attractive opportunities at the short end. 

Fig. 4 - Mind the lag

US 12-month trailing default rate and high yield spread, %

Emerging markets are potentially an intermediate investment. The US dollar has strengthened considerably against all currencies and particularly notably against the likes of sterling, the Japanese yen and the euro. But unlike previous risk-off periods, emerging market currencies have been relatively less of a casualty (see Fig. 5). And already more than 80 per cent of emerging market real yields are higher than those in the US.

Fig. 5 - Emerging stability

USD trade-weighted index vs developed and emerging market currencies, 27.10.2021 = 100

Part of that relative strength is down to the fact that emerging market central banks have been ahead of the inflationary curve, acting considerably more aggressively to recapture price stability than G7 central banks. As US interest rates start to stabilise, the dollar should also begin to edge back from its current highly overvalued state, which would be a boost for emerging market local currency debt. Meanwhile, the emerging market corporate bond sector is in a generally healthy state – leverage is relatively low, the companies issuing debt are by and large high quality and more of this debt is being held by domestic investors than in the past and therefore is less subject to panic selling. Both dollar denominated and local currency emerging market debt are well worth a closer look even if many investors are sceptical that this time really is different.

It’s still early days, but bond markets are more attractive to investors now than they have been for years, in some cases decades. Volatility and the risks of widespread and stagflation spreading are still a hazard to all risky assets. And the risk of accidents caused by policymakers can’t be discounted. But there are compensations for the risks investors face – and also rewards.