Bond Compass

Bond Compass: Opportunities in a Bond Bear Market

It’s time to make the best of a bad situation. Inflationary pressures persist, central banks are hiking rates and further bond market volatility looks likely. In our Q4 Bond Compass, we look at ways for fixed income investors to cope with these challenges, focusing on three areas: short-duration strategies, investment grade credit and hard currency emerging market debt.


Q4 2022


Safety First: Tread Cautiously with Short Duration

The summer rebound in the rates market did not last long and now, once again, short-duration strategies should be the focus. They are more defensive and, given how much policy tightening is priced into markets, short-dated bonds could start to rebound before the longer end of the curve.

The summer looked like it was the time to add duration exposure. US inflation was supposed to peak and growth indicators were slowing. In addition, following the first half sell-off, the markets seemed to be pricing a considerable amount of central bank tightening. Government yields did initially fall but stubborn inflation, coupled with the clear message from central banks that they would continue tightening until they saw a sustained decline in inflation, have forced government yields back higher again.

Peak Fear

So how should fixed income investors position for Q4? There are still reasons to favour a bit of duration in portfolios. The market has significantly repriced in response to aggressive central bank manoeuvring, which means that we could be close to peak fears over how high interest rates will rise. The rates markets currently price even more tightening than they did over the summer and, for the US, they are close to pricing a terminal rate in line with the Fed’s dot plots1 . As a consequence, yields are at levels not seen since April 2010 for the US 10-year and December 2011 for the 10-year Bund. Value destruction in equities has been even more extreme in 2022 and may prompt some investors to seek the safer alternative of bonds going into year-end.

That said, the crucial factor for the timing of the duration trade will be when US CPI starts to ease and that may not become evident until late in Q4. So, much like in Q3, investors will need to stay nimble, lengthening duration if the inflation numbers start to fall back in a sustained way. In the meantime, the aggressive stance of central banks and broader market instability point to short-duration positions.

Given negative returns across so many asset classes, many investors may prefer to hold a high weighting to cash in portfolios. It is certainly safe, but return potential is low despite the rate rises, with one-month deposit rates in USD at 3.1% and in EUR at just 0.7%. Another option is bills. Figure 1 below shows trailing 12-month total returns from the Bloomberg 3M US Treasury Bill index against the Fed Funds Rate during the 2016-2018 cycle. As can be seen, bills are the opposite of fixed income in that returns are positively correlated to rates. With the Fed expected to continue to raise rates, annual returns should rise further.

Figure 1: US Bill Returns vs. the Fed Funds Rate

Figure 1: US Bill Returns vs. the Fed Funds Rate

Turn of the Cycle

While relatively safe, returns from both cash and bills will be limited if market expectations for interest rate hikes turn a corner. Central banks will want to see a turn in inflation before softening the message on tighter policy but, importantly, they will be pleased that inflation expectations have started to moderate. US 10-year break-evens are close to their lows for the year. For those that fear this is distorted by swings in the Treasury market, both the New York Fed and Atlanta Fed surveys of inflation expectations have now started to decline2 .

Hawkish rhetoric is clearly doing its job at containing inflation expectations and, with the significant amounts of tightening that have already been delivered still to feed through into the economy, the turn in the rate cycle could occur quite quickly. Short-duration government funds would give investors some exposure to the turn in the rates cycle when it does occur. Front-end valuations have already been hit hard and there is a significant degree of tightening already priced. If this proves overly aggressive, then there will be scope for the front end of the curve to rally.

Figure 2 below illustrates the more defensive nature of the short, one to three-year part of the curve during the last Fed rate hike cycle versus an all-maturities strategy. The figure shows that 12-month returns for the one to three-year part of the curve moved into positive territory from early October 2018 while for the all-maturities index this did not happen until mid-December. So the tendency for the money markets to overshoot in pricing in policy tightening could drive short-end gains before these gains ripple out along the curve. Given the wild ride that markets have undergone this year, many market participants will be reluctant to take on meaningful amounts of duration risk until the case for lower rates becomes clear.

Figure 2: 12-Month Returns from Short vs. All-Maturity US Treasury Exposures

Figure 2: 12-Month Returns from Short vs. All-Maturity US Treasury Exposures

How to play this theme
 

Sticking with Investment Grade

Rising central bank rates and fears about recession continue to dominate the credit space. But for investment grade exposures, wide spreads to government bonds and high yields may start to draw in more investors.

For the second quarter running, we continue to favour investment grade credit. While this exposure did not escape the Q3 sell-off in fixed income, even the longer-duration Bloomberg SASB US Corporate ESG Ex-Controversies Select Index performed better than global aggregate exposures3 . For Europe, the tone was more cautious, which we believed warranted focusing on short-duration strategies; this defensiveness would have served investors well during the September sell-off.

There remain several features of investment grade (IG) exposures that investors could find appealing as we close out 2022.

Wide credit spreads. The most obvious point of interest is the aggressive widening in spreads to government bonds that has occurred this year. At the end of Q3 2022, US spreads were wider than in 2019, at the end of the Fed cycle, although not as wide as in 2016. This suggests that an economic slowdown is in the price, although not a period of prolonged negative growth.

In Europe, where energy supply issues have put pressure on corporates, spreads are now only around 25bp tighter than the wides seen during the COVID crisis. A part of this move reflects the fact that the ECB is no longer adding corporate assets to its balance sheet. Nevertheless, it would appear that a meaningful slowdown is already in the price of euro IG credit. Spreads may yet go wider if the deterioration in economic indicators accelerates. However, there is an offset and that is that a more meaningful slowdown is likely to make central banks more cautious.

As Figure 1 shows, spread widening does not always result in negative returns. Late in the 2015-19 Fed cycle, returns for the Bloomberg US Corporate index started to rise even though credit spreads were widening. Spread widening was in part driven by markets sensing a turn in the rates cycle, driving Treasury yields lower and therefore credit spreads wider, as well as by fears over the degree to which an economic slowdown may affect issuer credit quality.

Figure 1: Late-Cycle Performance of the Bloomberg US Corporate Index

Figure 1: Late-Cycle Performance of the Bloomberg US Corporate Index

Higher yielding assets. Higher government yields coupled with wider credit spreads makes for some interesting yields on corporate debt. Yields on the Bloomberg Euro Aggregates: Corporate Index are at the highest since early 2012 at 4.25% (yield to worst). Even the short-maturity Bloomberg Corporate 0-3 Year Total Return Index yields close to 3.5%, with a duration of just over 1.5 years4 . As late as the end of 2021, yields on this index were negative.

Limited evidence of a deterioration in credit quality. Low rates in 2020 and 2021 allowed companies to refinance debt at favourable levels. This should stand these issuers in good stead going into 2023, even if there is a material slowdown in growth. Figure 2 shows that there have been only mild signs of a deterioration in credit quality in 2022. Q3 saw a fall in the upgrades/downgrades ratio for IG issuers but it has fallen below 1 only in Europe for Moody’s actions (0.66). The number of “fallen angels” (IG companies downgraded to non-IG) has remained relatively low by historical standards for the US market. While they did rise in Q1 in Europe, they have remained low since then.
 

Figure 2: Upgrades vs. Downgrades Ratios and the Number of Fallen Angels Signal Few Stresses in IG Credit

North America

 Figure 2: Upgrades vs. Downgrades Ratios and the Number of Fallen Angels Signal Few Stresses in IG Credit

Western Europe

bottom chart (2) is Western Europe

IG credit repricing has been more extreme than for non-IG. The ratio of yield between high yield and IG paper is low. The ratio of the yield to worst of the Bloomberg Liquidity Screened High Yield Index and the Bloomberg Pan European Agg: Corporate 3-5 Years Index, which has a similar duration, is at just over 1.8. This is its lowest since March 20145 and indicates that the rewards for assuming additional credit risk are relatively low at this juncture.

If investors are seeking to bolster portfolio returns with even higher yielding assets, then they could do a lot worse than looking at the UK market. The yield to worst on the Bloomberg GBP Corporate 0-5 Year Index is close to 6.8%. Markets are already discounting BoE rates moving above 5.75% by the end of 20236 and, being maturity constrained, it has a duration of less than 2.5 years and so should display limited volatility to the BoE moving rates higher.

How to play this theme
 

The Case for Emerging Market Debt

Hard currency emerging market debt suffered far less from the global bond sell-off in Q3 2022 than many other exposures. Short-duration hard currency still has a strong risk-reward profile, wider diversification than local market exposures, and it can provide some peace of mind given a significant proportion of the index consists of issuers from oil-producing nations.

Risky Business

It has not been a vintage year for emerging market debt investors. The war in Ukraine, strength of the USD and local central banks trying to deal with high inflation have all weighed heavily on performance. There remain many issues to ponder: the Brazilian election, the twists and turns of the war in Ukraine, and economic problems in Turkey. However, emerging economies are not alone in trying to deal with risks. Just in the G10 countries, the UK mini-budget delivered a sizeable shock to asset markets, the US has its mid-term elections in November, and Italy has a new government that is, as yet, untested. We live in interesting times. Potentially, the gap in geopolitical risks between EM and DM is narrower than usual.

Fortunes of the USD

Clearly the biggest single question for emerging market debt is the USD. The US mid-term elections could precipitate some weakness but, while the global backdrop remains so volatile, it is difficult to see a material turn in the USD. The Fed will continue to raise rates at pace, there is likely to be a bid for defensive and liquid assets going into year-end (these are often USD denominated), and geopolitical tensions seem unlikely to evaporate any time soon. In short, while USD valuations are extremely stretched, we do not expect the global backdrop to change enough to see this strength abate.

Despite negative flows data and the ever-present risks in emerging markets, one of the themes for the Q3 Bond Compass was short-duration emerging market hard currency. While this exposure could not escape the market sell-off, returns were -0.9% for Q3, which pale against the nearly 7% fall in global aggregate7 . Until the USD starts to fall, it may be premature to switch into local currency; however, there are still reasons to like hard currency exposure:

  • The ICE BofA 0-5 Year EM USD Government Bond ex-144a Index has a favourable yield to duration trade-off. The yield to worst is 6.78% while the duration is 2.30 years, implying a yield of 295bp per year of duration. This is around 100bp higher than for US investment grade credit, but lower than US high yield. However, the credit rating on US high yield is typically lower than on the emerging market index8 . So the risk-reward trade-off from a duration and credit risk perspective looks strong, in our opinion.
  • The index is more diversified than most local currency indices, with issuers from 55 different countries. The issuer exposure is capped at 10% but, as of the September 2022 rebalance, there are only two countries close to that limit. There is a ratings cut-off of CCC to eliminate the least credit-worthy issuers. Indeed, as Figure 1 illustrates, the exclusion of country issuers at the month-end rebalancing is not unusual, the most notable being Russia at the end of March.

Figure 1: Evolution of the ICE BofA 0-5 Year EM USD Government Bond ex-144a Index Option-Adjusted Spread

Figure 1: Evolution of the ICE BofA 0-5 Year EM USD Government Bond ex-144a Index Option-Adjusted Spread
  • As a USD-denominated index, there is a high proportion of oil producers. Of the index, 23.4% of the bonds by market weight are issued by either OPEC or Persian Gulf economies and 41.6% are issued by one of the top-20 oil-producing nations. Oil has been above $75 per barrel for all of 2022, which compares favourably to the five-year average of $68.50 for Brent crude, suggesting USD inflows to these countries’ balance of payments will remain buoyant.

Figure 2: Breakdown of the ICE BofA 0-5 Year EM USD Government Bond ex-144a Index

Figure 2: Breakdown of the ICE BofA 0-5 Year EM USD Government Bond ex-144a Index

Overall, short-duration hard currency EM exposure offers a yield well above the level of Treasury or investment grade corporate exposure. There are risks in the EM world, but recent market moves highlight the fact that there are also significant risks in the supposedly “safe” bond markets of the G10. Being a USD-denominated exposure reduces risks of falling local currencies but, given how high valuations are for the USD, also represents a risk. For those who do not see the USD remaining well supported into year-end, there is the option to remove that risk via currency hedging.

How to play this theme


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