Commentary: High-quality value

Market outlook:

We believe fixed income is very attractive on a medium-term basis. This is because:

• Firstly, after the dramatic repricing of 2022, fixed income offers significantly better value. The jump in yields means prospective through-time returns will be higher, and at current yields, government bonds are ‘cheap’, both on an absolute basis given medium-term economic inputs, and on a relative basis to equities and other assets. Similarly, high-quality corporate bonds are ‘cheap’ relative to the likely range of default stress scenarios.
• Secondly, the cycle is turning in favour of bonds. We deem bonds to be worth owning simply for their higher yields – i.e. higher ratios of income to price – and the improved value this represents. However, the shift in the balance of risks from upside inflation to downside growth means there’s a decent probability we see bond prices rise, lifting total returns.

The recent better-than-expected growth data, particularly in the US, suggest the cycle swing in favour of bonds will take longer to materialise. This should not surprise, as we know that policy tightening impacts with famously long and variable lags, and the inflation process is now somewhat entrenched and difficult to reverse. Many corporates have been successful to date in passing on higher costs, and despite the real income squeeze, consumers have run down savings in order to keep spending. Meanwhile, the impact of higher rates is widely varied across economies – including benefiting savers.

Central banks looking for the end

We are confident that inflation will eventually moderate, and growth will weaken further as the effects of higher rates and other costs bites on discretionary spending of both consumers and businesses. With rates now in restrictive territory, uncertainty around the pace of rate hikes has eased, and central banks are searching for the endpoint to tightening. Meanwhile, the valuation argument for bonds remains extremely compelling.

While much of the policy easing that was factored into interest rates for late 2023 and 2024 has been removed over recent weeks, riskier assets are at valuations that assume a sharp downturn will be avoided. This seems optimistic, especially as such a large and rapid change to policy has just been administered. Even if corporates and households are able to ‘manage through’ and macroeconomic volatility does subside (meaning profitability does not decline substantially and unemployment does not rise too much),  risk premia ought to be higher for the uncertainty.

Positioning

Together these points lead to an ‘up in quality’ portfolio stance. High-quality bonds, both government and investment grade corporate, are very appealing sources of low-risk income and diversification over medium-term investment horizons. Australian investment grade credit stands out to us as particularly appealing given its high risk-adjusted spread.

Our strategy is to steadily accumulate high-quality assets at good levels, while being patient to wait for better opportunities in riskier assets. While eventually the downside risks to growth are likely to dominate market pricing, these may not eventuate for some time. This suggests we should embrace the good income on offer now in high-quality assets, and be flexible and prepared to firstly increase interest rate duration and later to add to riskier assets.

Our current portfolio settings are:

• Neutral to small long interest rate duration. We are long in the US and Australia, and short in regions where policy tightening is lagging, namely Europe and Japan
• Country-specific yield curve exposures. In the US we are overweight 2-yr Treasuries as we expect the yield curve to steepen from significantly inverted levels, while in Australia we are overweight longer maturities as our local curve offers better value. In Europe we expect pricing for further ECB hikes to push 5-yr Bund yields higher, while in Japan the 10-yr point is susceptible to further yield curve control adjustments by the Bank of Japan
• Moderately overweight investment grade corporates, mostly in Australia. This asset is offering good value, and should be insulated should credit conditions deteriorate. We also continue to run a small weighting to Australian residential and commercial mortgages.
• Low weightings in riskier credit. We have liquidated our small positions in Asian corporates and emerging market sovereigns, but retain a small exposure to Australian subordinated debt, with a small short position in US high-yield providing some hedging protection.

With fixed income now standing out as offering good absolute and relative value, and the cycle potentially turning in favour of bonds, we are confident 2023 will look significantly different for the asset class. We are positioned constructively in interest rate duration and high-quality corporate debt, and expect to become even more constructively positioned through the year.

Learn more about the Schroder Fixed Income Fund.