Investment Outlook: Bonds for What Comes Next
Aftershocks from last year’s inflation surprises and hurried policy response have continued to reverberate through the real economy and financial sector, leading to wild swings in fixed income market prices. Bond investors must now decide whether it’s time to remain cautious, selectively add risk, or take a wait-and-see approach. Here we consider three areas that could accommodate these aims: investment grade credit, emerging market debt and global aggregate exposure.
Q2 2023
Investment Grade Credit: Catching the Central Bank Turn
- Central bank rates seem close to a peak in the US and we look to investment grade strategies to provide duration and a yield pick-up to Treasuries. In Europe, the turn may be further away, meaning cautious investors might like to stay at the front end of the curve. The backdrop for ESG remains challenging – but more challenging for some approaches than for others.
Issues in the banking sector may have been contained but the feeling persists that they have changed the outlook for rates. First, banking woes are a warning that rate rises have been too aggressive. While this can be justified by persistently high inflation, with policy tightening still feeding through, there may be less appetite at the Fed to risk further instability by continuing to raise rates. The second factor is that credit conditions in the economy are likely to tighten. This does some of the work for the Fed. As a result, the market has concluded that an end to the policy cycle is near.
There are of course risks. Persistent above-consensus inflation numbers, coupled with resilient growth, could persuade the FOMC that more tightening is required. However, with banking issues in mind, the FOMC may be inclined to be a little more patient. This could provide further stability for fixed income markets in the coming months.
Staying Neutral Duration
For those investors who remain cautious, short-maturity strategies can reduce sensitivity to underlying interest rate moves. However, a more consistent approach to the view that rates are close to their peak is to focus on duration-neutral, all-curve strategies. Figure 1 shows the Bloomberg US Corporate Total Return Index plotted against the 2015-18 Fed tightening cycle. The index struggled to deliver positive returns during the tightening phase but, as the final rate hike came into view, returns became consistently positive. Gains continued to accrue as interest rates were cut and only reversed when the market priced in the COVID recession.
Figure 1: US Corporate Returns Gained Traction as the Last Fed Hike of the 2016-2018 Cycle Came into View
US investment grade provides around 140 bps of pick-up to the US Treasury curve, meaning that, in the event rates remain rangebound, investors will still be able to accrue higher coupon returns. Seasonal market factors also tend to be more positive into Q3 than they were in Q11. Exposure to corporates should leave investors less vulnerable to the debate over the debt ceiling if that becomes a market issue around mid-year. There are some modest signs of rating stress in the US, with the upgrades/downgrades ratio for Q1 2023 below 1 for S&P ratings actions, but we see no imminent signs of a growth collapse.
There are few indications of financial stress in Europe2 and, with investment grade spreads to government bonds still +50 bps to their 10-year average, this exposure is also interesting. However, the fact that the ECB remains behind the Fed in its tightening cycle, coupled with the stickiness of core inflation, means we would be more cautious on extending duration too far in Europe.
The BoE is potentially somewhere in between, with inflation reluctant to fall but higher central bank rates and a more dovish-sounding monetary policy committee suggesting the end of the policy cycle is close. Wide credit spreads (190 bps on the Blomberg Sterling Corporate Bond Index) do provide a degree of protection from the weaker growth dynamic expected this year in the UK.
ESG in the Spotlight
Troubles in the banking system have kept the pressure on ESG strategies, many of which have a high allocation to financials. While this may assist with improving the environmental profile of an ESG index, recent challenges have raised questions on the degree to which index providers are incorporating issuers with a strong governance profile. Even with raised governance requirements, high allocations to financials have acted as a drag on performance. Looking at the index sector weightings of the three largest investment grade European ESG ETFs by AUM shows that, for US corporates, they have a 5.7% overweight to banks relative to the standard market-weighted index, while for Euro Corporates it is 7.6%3.
The methodology employed to build the Bloomberg SASB ESG Ex-Controversies Select indices takes a different approach to weighting. Once exclusions have been made to remove any issuers that derive revenue from controversial business practises, the remaining index constituents are optimised. There are dual objectives, with the optimisation seeking to maximise the R-Factor4 score while at the same time pushing the characteristics of the index back toward those of the parent index.
In the current environment, this has two advantages. First, the R-Factor ESG score has a specific governance overlay, meaning those with a poor framework should score badly. And second, the alignment of Bloomberg Class 2 sector weights to within 200 bps of the parent index results in a far lower weight to financials. The Bloomberg SASB US Corporate ESG Ex-Controversies Select Index is actually 26 bps underweight financials compared to the parent index, while the Bloomberg SASB Euro Corporate ESG Ex-Controversies Index is 2.2% underweight. This could provide reassurance to investors who are still cautious on the outlook for financials.
How to Play this Theme
Emerging Market Debt: Emerging Markets Ready to Start Easing?
- Emerging market (EM) debt has performed strongly during the past six months. While further USD depreciation is likely to be more gradual, it should remain supportive for EM. High coupon yields will also bolster performance. The big question is whether EM central banks will start to ease policy. A heavy inversion of the front end of the curve hints that the market expects movement soon.
EM debt has enjoyed some robust gains over the past six months with the Bloomberg EM Local Currency Liquid Government Index returning close to 13.9%5. Returns took a knock in March as banking sector instability saw market participants pare back risky asset exposure and the USD firmed, but there was a solid recovery into the end of Q1.
Figure 1: Country Currency and Bond Returns over the Past 6 Months
The key driver of returns has been the weaker USD, with currency returns from Q4 2022 to the end of Q1 2023 period at 6.7%, as can be seen from Figure 1. This return came largely on the back of the rebound in Eastern European currencies, but was also helped by double-digit returns from Chile, Mexico, South Korea and Thailand.
Bond price returns were also, for the most part, positive (+4.0% for the index overall) as market participants sensed the turn in the EM central bank cycle. Aside from Turkey, none of the other 17 central banks that make up the Bloomberg EM Local Currency Liquid Government Index have actually cut rates yet. However, the 0-2 year curve slope has now inverted for 12 of those markets, suggesting market participants believe that a majority of central banks will start to ease policy in the coming quarters.
The Quarter Ahead – Easing Coming Down the Pipeline?
Bond gains are seen as a key potential source of returns for EM debt over the coming couple of quarters. The more aggressive approach to combatting inflation seen from many EM central banks means that inflation is believed to have peaked in several key markets, such as Brazil, Mexico and South Korea. The front end of the curve is the most inverted as it has been since 2016 (Figure 2). Further hikes may only serve to invert the curve further but, at some stage, many of these central banks should move to validate what is priced in the curve. If they do not, then currencies may appreciate, putting more downward pressure on growth.
Figure 2: Front End (0-2 year) Curve Inversion Points to Expectations of Policy Easing
Returns from currency are less predictable. The USD is unlikely to repeat its sharp declines from Q4 last year but it could still act as a support if it weakens. We believe there is a chance that it does for two reasons:
- The model of long-term USD value, run by State Street Global Advisors, still estimates that the basket of currencies that makes up the Bloomberg EM Local Currency Liquid Government Index is 10.4% undervalued versus the USD (as of 31 March 2023). So we anticipate that the weakening USD will continue in the longer term, but near-term price action will be more dependent on how dovish the Fed becomes. The risk to this view is that in an environment where EM central banks start to ease policy rates and the Fed is hawkish, USD strength would likely persist.
- Troubles in the US banking system, and possible issues with the debt-ceiling negotiations later in the year, are not seen as a favourable backdrop for the USD. While the USD typically benefits in a crisis, when it is a homegrown affair it is less obvious that a crisis would prove supportive.
In summary, EM local currency debt should find support from the central bank policy turn, which we expect to see in the coming months. A further weakening of the USD may also support returns. The exact timeline is unclear, but with the yield to worst on the Bloomberg EM Local Currency Liquid Government Index at around 6.25%, or close to 100 bps above its 10-year average, investors should continue to benefit from meaningful coupon inflows even in the event that market conditions remain stable.
How to Play this Theme
Global Aggregate : Waiting out the Uncertainty
- A range of possible outcomes for the path of rates is common as the end of the policy cycle approaches. The lack of clarity has been further complicated by concerns around the stability of the banking sector. This uncertainty has understandably induced caution in investors. One potential solution is to diversify risk with a global aggregate exposure.
In the Q1 Bond Compass, our theme ‘There is an Alternative in the Short End’ highlighted the advantages of allocating to the short end of the rates curve while waiting for a clearer picture to emerge. After all, the backdrop to markets had changed substantially with investors no longer penalised for holding short-dated exposures. Yields at the front end remain high, so allocations to short strategies can still make sense for risk-averse investors. However, as discussed in our other themes this quarter, the present stage of the central bank cycle means it may pay to take on more duration risk.
It’s Got the Big D
One way to navigate the current market is through diversification with a global aggregate exposure.
- Global aggregate is an investment grade exposure and thus should not be vulnerable to a sharp slowdown in activity in the same way that strategies such as high yield would be. In fact, the large weight of US Treasuries in the index (16.7%) means that it has performed well in the two years when US GDP has recorded negative growth: in 2009 the economy shrank 2.6% and the index returned +6.9% while in 2020, during COVID stress, GDP contracted 2.8% and returns were +9.2%6.
- It is an extremely well diversified exposure, containing more than 3,200 issuers, which dilutes exposure to any one central bank’s policy cycle. 2022 was a down year for aggregate strategies (-16.2%) because most central banks rushed to raise rates at the same time. Some respite came from exposure to Japan and China debt (about 22% of the index), both of which had different policy cycles, but most central banks were forced to raise rates by soaring inflation. Expectations that the peak to rates is close (for the US, UK and many emerging markets) should limit downside price risks.
- Outside of the geographical spread, there is product diversification with around 18% of the strategy in corporate bonds and 14% in various forms of securitised bonds. These behave in a different way to government debt and could provide an offsetting source of returns if growth remains more robust than anticipated. There would be upside rate risk, but credit spreads would likely contract as fears of a meaningful slowdown subside.
- The prevalence of USD-denominated securities is evident within the index (44.5%) and, for this reason, there is a correlation to Treasuries. So any Fed policy easing or a twist to more dovish rhetoric should be reflected. However, from a historical perspective, global aggregate actually looks somewhat cheap compared to US Treasuries. Figure 1 shows the relationship between the yield to worst on the Bloomberg Global Aggregate Index and the US 10-year Treasury yield. During the period of a fairly stable relationship, seen in 2016-2021 (excluding 2020 and the COVID-induced disruption), global aggregate yields were considerably lower for a given 10-year US Treasury yield than is the case at present. There have been changes to the composition of the index, most notably the inclusion of China from April 2019, but this does not explain the substantial cheapening of aggregate exposure to Treasuries. This is more likely to be driven by corporate credit spread widening but does still indicate that the aggregate index currently provides higher than historically normal yields relative to Treasuries.
Figure 1: Yield to Worst on Global Aggregate is Above Levels Implied by 10-Year US Yields
This final point is significant. It means investors can now receive a yield of around 3.5%, largely in line with the US 10-year Treasury, when usually they would have been forced to accept yields below what was on offer from the US 10-year. In addition, there are so many moving parts to global aggregate that it does not respond quicky to market signals, indicating that there may also be a higher degree of stability once invested in the strategy – a meaningful consideration given the high degree of volatility seen recently in US Treasuries. For investors concerned about USD weakness, there are a variety of strategies that hedge out currency risks.