Patience Is a Virtue: Finding Opportunities in Fixed Income
Investors should prepare to make shifts in their portfolios as peak policy tightness draws closer — preserving liquidity and exercising patience in identifying entry points.
The rising rate environment of 2022 has been incredibly painful for investors. Against a very challenging past 12 months in fixed income, there is a silver lining: a lift in income. Current yield levels across most of the major fixed income sectors are either at 10-year highs or at the higher end of these ranges. The yields on US and European Investment Grade Corporate bonds have risen to 6% and 4%, respectively; the yield on the 10-year US Treasury has more than doubled to 4%; the yield on German Bunds increased to 2%; and the yields on High Yield and emerging markets (EM) bonds globally have jumped to approximately 9% (see Figure 1). While price returns have been painful, investors are now getting more income from their fixed income than they have for quite a while.
Figure 1: Bond Yields Reach Highest Levels in a Decade
Sources: Bloomberg Finance, L.P., JP Morgan Chase. Analysis uses daily yields-to-worst from October 31, 2012, to October 31, 2022. HC = Hard currency and LC = Local currency.
There is growing evidence that we may be nearing a peak in rates, as aggressive central bank policies targeting inflation take effect. This potential peak in rates could turn the very significant headwind in the bond market of the past year into a tailwind. Central banks, well into their tightening cycles but recognizing the lagged nature of monetary policy transmission, are currently walking a tightrope between appropriately restricting economic activity (to help ease inflation) and policy overtightening (causing a “hard landing” recession). Investors will have to walk this tightrope as well, and should be ready to make shifts in their portfolios as peak policy tightness draws closer and becomes more apparent.
Our message to investors is to exercise patience in choosing entry points and to maintain liquidity in portfolio positioning. Regarding timing, investors can look at trends captured in macroeconomic surprise indices (see Figure 2), the index of leading indicators, the Purchasing Managers Index (PMI), among others — all of which point to a slowing global economy.
Figure 2: High Inflation Uncertainty and Upside Surprises Pull Yields Higher Across the Curve
Sources: Citigroup, Bloomberg Finance, L.P., as of October 31, 2022. Macro surprise indices are the Citi Inflation Surprise Index and the Citi Economic Surprise Index for the US. “MA (12)” denotes 12-month moving average.. FFR = Federal Funds Rate
US Treasuries as Diversifiers
Liquidity can take many forms — and is all relative. First, investors should consider the possibility that Treasuries and other developed market (DM) sovereigns could once again become effective diversifiers alongside risk assets in the coming quarters. Given high inflation uncertainty over the past 18 months, the traditionally negative correlation between equities and bonds that has persisted since 2000 has broken down and become positive in 2022. If disinflation prevails in 2023 and economic growth slows as expected, that correlation could become negative once again — i.e., with the Fed cutting rates, yields heading lower (bonds rallying), and equity valuations reflecting the deteriorating fundamental environment. This would increase the attractiveness of US Treasuries as a liquid downside protector in an asset allocation context.
High Yield as a Liquid Proxy for Private Credit
Many investors have made allocations to private credit, drawn by an attractive level of income that reflects a significant liquidity premium. The drawback of private credit is that its liquidity can best be described as periodic, and many investor portfolios require more flexibility. Cash generated from private investments requires reinvestment, and the structure of private investment programs often requires committing capital up front with deployment of those assets dependent on investment opportunities. Therefore, an investor in private credit must consider where to keep cash associated with the private program. Of available alternatives across public markets, High Yield bonds stand out as having a yield level approaching that of private credit along with a relatively high correlation with the quarterly marks of private assets (see Figure 3).
Figure 3: High Yield - A Close Liquid Proxy for Private Credit
| Asset Class | Market–to–Market/Liquidity | Correlation with US Private Credit* (Quarterly Return) |
Expected Yields** |
| US Private Credit* | Periodic | – | 8–12% |
| US High YIeld Index | Daily | 0.81 |
5 – 9% |
| US Aggregate Bond Index | Daily | –0.06 | 2–5% |
| S&P 500 Index | Daily | 0.67 | 1–3% |
| Cash | Daily | –0.30 | 0–2% |
*Private credit is represented by the Cliffwater Direct Lending Index (CDLI). ** Expected yields are based on historical ranges for the trailing 10-year period. The Bloomberg US Treasury Bellwethers 1-month Index is used as a proxy for cash. Source: Cliffwater Direct Lending LLC, Bloomberg Finance, L.P., as of June 30, 2022. Analysis is based on quarterly returns going back to June 2012. The above targets are estimates based on certain assumptions and analysis made by Cliffwater Direct Lending LLC and Bloomberg. There is no guarantee that the estimates will be achieved. All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment.
While the periodic mark-to-market of private credit yields benefits in terms of enhanced income and “stable” pricing, investors looking to take advantage of market dislocations would find themselves challenged to do so if investing only in private markets. By using the liquidity and volatility of High Yield, investors can take advantage of widening spreads by buying credit when it falls in price during market dislocations, with the intention of redeploying in private credit or other alternative asset classes when those opportunities arise. In Figure 4, we have identified five instances where High Yield spreads approached or exceeded 6%, representing points in time when buying High Yield as a proxy for private credit capital would have resulted in enhanced returns.
Figure 4: Leaning into High Yield When Credit Spreads Are Favorable
High Yield Spreads versus Rolling Annual Income of Private Credit
Source: Cliffwater Direct Lending LLC through June 30, 2022; Bloomberg Finance, L.P., as of September 30, 2022.
Be Patient in Waiting for Attractive Entry Points on Credit
Credit spreads have widened this year from near-historic tights and are now at levels that are in the context of long-term averages. We think credit will be a buying opportunity in the coming quarters, but it still faces some near-term headwinds. A key headwind is an aggressively tightening Federal Reserve that the market expects will raise the Fed Funds rate to 5% in the first half of next year. This reflects highly restrictive territory and will further dampen economic activity. These tightening effects have, for the most part, not yet shown up in credit fundamentals, but we think they will in 2023 (tightening effects have started to show more clearly in macroeconomic fundamentals). Investment Grade credit fundamentals, although slowing, continue to hold up: profit growth remains above pre-Covid averages, while interest coverage ratios are near historical highs. On the High Yield side, spreads remain slightly rich to longer-term averages, and do not reflect the uptick that some analysts are predicting in High Yield defaults next year.
Closing Thoughts
We need to see clearer signs that the Fed is prepared to actually pivot off of its policy tightening path in order to make credit, particularly High Yield, an attractive investment opportunity. Even after the 75-basis point hike in November, the Fed still has multiple rate hikes left to implement before it pauses, barring some unforeseen strong downside macroeconomic surprises. In the meantime, momentum is likely to remain negative, fundamentals are likely to weaken, and spread valuations are likely to widen further to more attractive levels. Patience is prudent while waiting for the macroeconomic and policy picture to become clearer over time — we’re not there yet.