Commentary: Fixed income is improving, but challenges remain
Higher inflation and looming central bank tightening means that the fixed income environment is likely to remain challenging for some time. While we’re managing the portfolio cautiously at present, we’re optimistic that further volatility will provide good opportunities to re-set fixed income allocations more constructively.
Global bonds suffered their worst ever quarter on record, as markets priced in aggressive interest rate increases by central banks, sending short-dated bond yields significantly higher. Additionally, corporate bonds underperformed government bonds with credit spreads widening on a combination of higher geopolitical risk and central bank tightening fears. The key issue is inflation, which rose to multi-decades highs of 7.9% in the US and 7.5% in Europe, supported by the largest quarterly increase in commodity prices since 1973 (+25%). The war in Ukraine created additional volatility but ultimately turbo-charged the inflation and bond story by creating more supply-side shortages in key energy and agricultural commodities.
Is fixed income good value now?
One obvious aspect that emerges from the bond market maelstrom is that fixed income assets are clearly cheaper than previously. US and Australian markets are pricing a cash rate of close to 3% in a year’s time. Whether fixed income is good value yet is a debate between cyclical factors becoming more favorable, but longer-term structural forces shifting negative.
On the cycle, central banks are now clearly on a mission to contain inflation. This message has been coming through clearly from the RBNZ, the Bank of England and the Bank of Canada for some time, and more recently very forcefully from the US Federal Reserve. The RBA and the European Central Bank have been laggards but are also shifting to a more aggressive stance, as inflation continues to surprise, leaving the Bank of Japan as the lone dove amongst developed market central banks.
Arguably this shift has come too late, as inflation moved beyond transitory some six months ago and is now broadening out beyond supply-constrained goods to services and wages. An ‘inflation psychology’ (the RBA’s new term) appears to have developed.
Can central banks ‘stick the landing’?
Now that central banks are (belatedly) responding to the inflation threat, the key cyclical question is whether they can ‘stick the landing’, i.e. can central banks engineer lower inflation without sending economic growth plummeting? The US interest rate market is skeptical – the yield curve is beginning to invert, implying rate increases will need to be reversed – and the historical evidence is not good; typically, central banks over-tighten policy, leading to a recession. This suggests that, while perhaps not just yet, good cyclical value in bonds will emerge as we move through the tightening cycle and the balance of risk shifts from higher inflation to lower growth.
At face value, Australian bonds look attractive on a relative basis as it seems unlikely the RBA will be able to raise official rates by more than the US Fed, as is currently priced into the yield curve. This unlikeliness arises from the greater sensitivity of the Australian economy to the cash rate – our household debt being much larger, and largely in variable rate form. However, we expect Australian bonds to continue to either trade in lockstep with, or even further underperform, US bonds until this distinction in the policy cycle becomes more apparent.
The structural issues centre on the question of whether we are entering a new regime of permanently higher inflation. It would seem too early to conclusively answer this question. On the one hand, key structural downward forces on inflation, such as aging demographics and high debt load, remain in place. On the other, decarbonisation and other effects of climate change are (for now at least) increasing energy costs, as will a shift away from globalisation and increased geopolitical risk, if these become more persistent.
The implications of higher inflation
If we do enter a higher inflation regime, this has two serious implications. The first is that the bond bull market spanning the last four decades, underpinned by disinflation, is likely over. That’s not necessarily a bad thing for bond investors as higher yields set up better future returns, but it will mean the positive disinflationary tailwinds are a thing of the past. The second is that bond-equity correlations may move back to positive, as has been the case historically in environments where inflation has been higher than 4 or 5%. Again, this is not necessarily bad for bond investors, but it will cause a rethink on multi-asset portfolio construction techniques, including the traditional 60/40 balanced portfolio and risk parity approaches.
The yield premium on corporate bonds over government bonds is also undergoing a readjustment, primarily related to central bank tightening. The first element is that not only will central banks lift cash rates, they will also sell down the assets accumulated through their quantitative easing (QE) programs. While this may not involve active selling of the bonds purchased, it may simply take the passive form of not reinvesting the proceeds of maturing assets. In either case the central bank will be withdrawing liquidity from the market. To the extent that central bank balance sheet expansion has supported risky assets of all forms, liquidity withdrawal is likely to have the opposite effect. In our estimation, anticipation of liquidity withdrawal has been, alongside funds flow driven by concern over rising rates, the primary driver of wider spreads this year.
The second element impacting corporate bonds is that over-tightening by central banks, in an effort to rein in inflation, may trigger recession. Recession drives credit spreads wider as profitability and ability to service debt drops, increasing risk of default. We don’t think the move wider in credit spreads so far this year reflects this risk, evidenced by the outperformance of high yield credit which is more vulnerable to recession. Our models are not suggesting imminent recession, but we expect indicators of recession risk to begin flashing soon.
Drawing these points together, fixed income is clearly better value now than several months ago, by virtue of the rise in bond yields and the widening in corporate credit spreads. However, the outlook remains challenging. The tightening cycle is just starting, it is unclear whether the actual delivery of the interest rate increases will be able to tame inflation, and for lower quality corporate credit, the risks remain skewed to downside at least until valuations cheapen further. Given this assessment, our approach is to remain patient. The worst of the repricing is perhaps behind us, however, opportunities will arise as the repricing continues. We’ll look to take advantage of those with more constructive positioning that will set up stronger returns from fixed income.
We are running lower interest rate risk than the benchmark and have a cautious stance on corporate credit.
Our key interest rate positions include:
- short duration positions in the US and Europe, as we expect yields to continue to rise, driven by inflation pressure and central bank tightening, and yield curve flattening exposure in the US, Europe and Australia. We expect most of the upwards yield pressure to continue to occur in shorter maturities, relative to longer. In Australia, we expect the market to continue to bring forward expectations for the start of the RBA tightening cycle
- a long position in Australian inflation linked bonds, as we believe Australian inflation is catching up to that in the rest of the world, and this risk is under-priced.
Together these should help to insulate the portfolio from further increases in bond yields. Although we expect that the bulk of the interest rate repricing has now probably occurred, we expect yields to continue to rise as rate hikes are delivered.
Our key credit exposures are:
- exposure to Australian investment grade credit, a high quality, low volatility asset class, which has already repriced to a larger degree than global investment grade peers
- small short positions in US investment grade and US high yield, which are potentially vulnerable to Fed tightening and balance sheet reduction
- small long positions in emerging market sovereign debt, and Asian corporates, which each offer considerable value, despite some cycle headwinds
- small exposures to Australian higher yielding corporates, mortgages and commercial loans.
In the context of the opportunity set and our historical positioning, our credit allocation, at a net 29% of the portfolio, is moderate. This reflects concerns about the ongoing challenging central bank liquidity environment, and potentially looming recession risk. We have reduced our exposures considerably over the last six months, particularly in riskier credit. From here we will likely trim our total exposures further, though the improvement in valuations we have already seen in investment grade will continue our shift in favour of investment grade over high yield corporates.
Overall, our positioning remains cautious. However, while we see the fixed income environment remaining challenging for some time, we expect we will be moving the portfolio to more constructive positioning later this year, which will set up the portfolio for better returns ahead. Patience is required as we navigate this difficult period.
Learn more about the Schroder Fixed Income Fund.
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