Don't look back in anger: Why credit deserves a fresh start
The bond sell-off has been truly bruising, but it’s important not to be haunted by past returns. Yields are attractive, the market is reinvigorated and we think it is time to be bold and get back in the saddle.
The extent of repricing of bonds over recent months has been remarkable. With multi-decade high inflation a key cause of the recent turmoil, it is not that surprising bonds in particular have suffered a painful correction.
As central banks have turned hawkish and started raising interest rates, markets have rapidly discounted significant, even aggressive, hiking cycles, perhaps to an excessive degree.
The macro picture has changed significantly, and investors should consider whether the discount rates applied to financial assets are reflecting heightened potential for risk appropriately. Fixed income markets have seen some of the most dramatic adjustments this year.
Investors commonly value bonds by taking a forward-looking view of expected policy interest rates, expected inflation, liquidity and default risks and adding that to the bond yield. So expectations for rising interest rates, inflation and economic stresses push bond prices lower, and yields higher.
Concerns over inflation and central bank hawkishness emerged in mid-2021. Since then, we have also seen the onset of a war in Ukraine and reintroduction of stringent Covid lockdowns in China. From a purely economic or investment view, these have sharply exacerbated supply chain disruptions, fuelled inflation and hurt economic sentiment.
Credit offers value relative to other asset classes and income opportunities
Bond markets have re-priced macro risks much more quickly and extensively than equities, as shown by the yield moves in the chart below.
Bond markets are generally transparent and efficient, adjusting for risks on a frequent and forward-looking basis, with yields changing accordingly. This means they can re-price more quickly than private assets, which take longer to adjust.
As a result, the sell-off in public fixed income markets means their valuations now look attractive compared with private assets, in our view. In the past few years, investors have switched significant capital to private assets, partly because of low yields from liquid bonds. We think the balance could start to shift more in favour of public or liquid bonds from here.
To put the re-pricing in historical context, the current drawdown across fixed income markets has been the largest in over 20 years. With low yields offering little cushion to offset the fall in prices, the onset of high inflation, slowing growth and central bank hawkishness combined to precipitate a collapse in sentiment.
The chart below highlights the dramatic increase in yields across credit markets since the beginning of the year.
Additionally, as illustrated in the chart below, the income pickup that investment grade corporate bonds offer relative to deposit rates is looking very attractive again. (chart below).
Overall, the extreme decline in sentiment has been a very powerful technical driver in global credit and US Treasury markets.
As we can see from the chart below, sentiment hit extreme panic territory, indicating that the market is overcompensating for risk. The good news is extreme weak sentiment tends not to last very long as cooler heads return. There are initial signs that we have seen the low point in terms of sentiment.
In “normal times” we would expect a low or negative correlation between risk assets and “risk-off” assets. In this episode, however, they have correlated quite closely, an indication of how extreme conditions have become. Therefore, going forward we expect a normalisation in sentiment.
We see the macro situation shifting more favourably for bonds over time. We expect inflation to peak during the second half of this year before stabilising as supply/demand imbalances should gradually improve. But we should also remember that due to base effects, we only need to see less severe price rises for inflation to start coming down.
We are seeing the initial signs of growth slowing. Nearly all major economies are either decelerating or slowing down, according to leading indicators. China is suffering the negative effects from stringent Covid lockdowns. In the US, there are signs of pressure on the consumer, some signs that jobs growth is moderating and softness in the housing market.
It is quite possible that inflation is a factor in this since the rising prices of goods, energy and food particularly, are acting as additional taxes on the consumer. Consumption may hold up for some time, but inflation will eat into the volume of goods purchased.
At the same time monetary tightening will also have a dampening effect, particularly as this is occurring late in the economic cycle. The Federal Reserve (Fed) and others have acknowledged this in recent communications.
The combination of slowing inflation and slowing growth will reduce the pressure on central banks to tighten further than the market is already expecting.
With bond markets already pricing in a lot of inflation and interest rate risks, we are likely to see these pressures on the bond markets softening.
Having said that we are mindful that there are several risks that can lead to further market volatility. The good news is, that the current yield level provides us with a healthy buffer against further drawdowns.
Fundamental strength will limit severity of the default cycle
As growth slows and company profit margins can face headwinds from higher input costs, the risk of less financially sound companies defaulting on their bonds is elevated. Again, we have seen a lot of this risk now priced into high yield bond valuations. However, the starting point for corporate fundamentals as illustrated by the leverage metric below is much stronger than what we have seen in the past.
Corporate debt levels do not seem to present a problem. Company fundamentals and balance sheets remain healthy as they have refinanced at lower yield levels and/or extended average debt maturity.
Corporate bond spreads have already widened to reflect the stresses that companies are under from higher input costs and slowing growth expectations. The risk premium priced into the market is already similar to previous recessions.
A recession is a possibility. Strong company fundamentals mitigate this to some degree and will limit the severity of a potential default cycle. Active management and careful issuer selection is crucial though.
In fact, we think that yields are overstating default risk and therefore the market is overcompensating. In fact, the default rate that is implied within the European high yield market suggests a default rate of 8-9%. To put this into context, Moody’s base case is for default rates to reach 3-3.5%.
Yields offer a much better starting point for future returns
The return potential for bonds looks considerably better. Yields are at much healthier levels, compensating investors for risks and providing a cushion against still volatile macro conditions and any future price corrections.
The chart below shows that in the year that following a stress event, corporate bonds have generated strong returns.
During significant market corrections, it is quite natural for emotions to take over and influence our decision making. However, to achieve the best outcomes it is important not to be governed by these emotional scars and focus on value.
If we do that, we will see that fixed income has undergone a major change over the past 12 months. In our view, it is returning to its more traditional identity as a structural, active component in a diversified portfolio, delivering yield and potential attractive capital gains. Yields and spreads look attractive in their own right as well as providing a cushion to further set-backs, while other assets may well prove more vulnerable to slowing growth. Dispersion has widened creating security selection opportunities for active investors, with good quality companies having been hit by indiscriminate selling.
For those prepared to be look forward from the last six months’ returns, we think there is a strong fundamental case to get back in to credit here.