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A Letter from Our CIO: Indexed Fixed Income Update

The 2023 bond market sentiment has so far favored a soft-landing scenario, and advances in bond market transparency have enhanced efficiency in high yield securities trading.

CIO, Global Fixed Income, Currency & Cash

2022 will likely go down as a year that many bond investors would like to forget. Stubbornly strong inflation led to the Fed hiking more times than many predicted. At the start of 2022, markets were pricing-in a total of 75 bps across three 25 bps hikes for the entire year. Amid concerns of further supply-driven constraints brought on by Russia’s invasion of Ukraine, by the end of the first quarter, markets had priced in over 2.00% of collective hikes across eight-plus meetings, stretching into 2023.

By the end of 2022, the Fed had increased the Fed Funds rate seven times by a total of 4.25% (equivalent to seventeen 25 bps rate hikes). In addition, the Fed moved to increase the rate by 25 bps in February 2023 and markets are pricing-in an additional two hikes in 2023. The Fed delivered on its claims that it would stop at nothing to curb inflation and to the Fed’s credit, inflation has fallen from its peak levels but remains well above the stated 2% target. These outsized rate moves – and the steep economic price that might accompany such move – roiled fixed income markets, with every major fixed income index delivering negative returns in 2022.

The bond market environment of early 2023 has been reflective of market sentiment that favors more of a soft-landing scenario, evidenced by every major bond index posting positive returns in the first month of the year. It is uncertain how long this euphoria will last, especially as we continue to see strong jobs and household spending data which could lead to even more hikes from the Fed, and a soft landing more difficult to achieve.

Figure 1: Bloomberg Index Total Returns

Figure 1:  Bloomberg Index Total Returns

Amid meaningfully higher interest rates globally, our fixed income assets under management fell 9% over 2022, ending the year at a total of $511 billion. While in market value terms assets fell, we saw meaningful client cash inflows over the course of the year: 2022 saw net inflows of $38 billion, the second highest net inflows of the past ten years. Client flows reflected both de-risking and re-risking activity: Nominal Treasuries and global sovereigns saw the strongest inflows at $41 billion for the year and were fairly equal-weighted across the curve.

Figure 2: 2022 Fixed Income Indexing Flows by Subsector

Figure 2: 2022 Fixed Income Indexing Flows by Subsector

Inflation-linked securities saw outflows as inflation waned throughout the year. As the year closed, re-risking activity became more prevalent: In Q4 we saw increased interest in more credit-risky sectors: $5 billion in high yield, $874 million in emerging markets, and $780 million in investment grade credit.

Figure 3: 2022 Fixed Income Indexing Flows by Channel

Fixed Income Indexing Flows by Channel

Broadening Our High Yield Horizons

Advances in bond market pricing transparency, data, and trading practices have contributed to rising efficiency in the trading of high yield securities. While liquidity in high yield will continue to rise and fall as investors’ risk appetites change, these advances have translated to less differentiation between what were once referred to as “Very Liquid” high yield bonds and the high yield market more broadly. With that in mind, we effected a benchmark change for a number of our commingled vehicles to replace the legacy Bloomberg US High Yield Very Liquid Index with a broad high yield benchmark, the ICE Bank of America US High Yield Constrained Index.

Both measures have similar quality and industry profiles with the main differentiator being that the Bloomberg US High Yield Very Liquid Index is slightly narrower from an issue and issuer perspective given its focus on more liquid issues. Our analysis suggests that any marginal liquidity benefits investors may have in the “Very Liquid” index have been offset by improvements in market transparency and trading innovation.

Closing Thoughts

As always, we value your business and look forward to our continued partnership in 2023 and beyond. Should you have any additional questions surrounding your investments or the markets, please do not hesitate to reach out to your client relationship manager.

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