Perspective

Patience: liquidity is key for coming opportunities in fixed income


Global asset returns in 2022 are among the worst on record. A 50/50 equity and bond portfolio has resulted in the worst year-over year real returns since 1974 and the drawdown in global fixed income markets has been simply unprecedented. We are facing our first global bond bear market in 70 years; the year-over year nominal returns of GDP-weighted global government bonds is -20%. The last nine months of bond returns have wiped out the last 10 years of profit. The performance we have experienced so far this decade eclipses anything we have observed in the last 200 years, even during the high inflation period of the 1970s (Figure 1).

Figure 1: Developed market nominal bond returns (annualized) per decade since 1800

Source: Deutsche Bank. Past performance is not a guide to future results.

While inflation scorches at 30-year highs, global bond markets have declined, leading to significant repricing of other asset classes. This year nearly all global financial assets have posted negative returns, demonstrating worse carnage than what the Global Financial Crisis inflicted. That’s the bad news.

The good news is that we believe the future prospects of higher quality fixed income today are more favorable than they have been for some time. Absolute yields are at their most attractive levels in over a decade. For example, 2-year Treasury yields have moved 20x higher in a year. Higher quality fixed income screens as attractive vs. higher risk asset classes (Figure 2). We believe that as the economy stalls, inflation peaks and the Federal Reserve (“the Fed”) steps back, the potential for strongly positive fixed income returns will be dizzying compared to earlier years.

Figure 2: Investment grade corporate yield to worst versus S&P 500 dividend yield

Source: Bloomberg. Past performance provides no guarantee of future results.

The negative returns and volatility of the first half of the year spilled over into the third quarter as central banks globally continued to withdraw liquidity in an effort to rein in historically elevated inflation. As the quarter progressed, and inflation’s tenacity endured, the market began to discount more seriously the prospects of an economic decline as hope that the Fed might pivot faded. Risk assets, which had held up fairly well during most of the quarter, began to sell off as the macroeconomic backdrop deteriorated and market instability in the UK dominated headlines. Furthermore, leverage that has hidden in unexpected places, such as UK pension funds, has begun to unwind and will likely continue to do so, increasing the probability of more surprising impediments to performance. During the quarter there were few places to hide; the only assets to post positive returns were silver and the Brazilian equity market (Figure 3).

Figure 3: Third quarter total return performance of major global financial assets (in local currency)

Source: Deutsche Bank and Bloomberg. Shown for illustrative purposes only and should not be viewed as investment guidance.

US fixed income assets have posted large drawdowns. Given the material move in rates, long duration bonds suffered a particularly hard blow (Figure 4). However, every fixed income sector is gasping for air. While the negative numbers in Figure 4 are entirely aberrant for most market participants, the positive side is that yields are more enticing now over the last decade and nearly uniformly place in the top quartile across all indices when viewed over the last 20 years.

Figure 4: A difficult year results in the most attractive yields in a decade

Source: Bloomberg and ICE BofA Indices as of September 30, 2022. Past performance provides no guarantee of future results.

Central bank headwinds: volatility usurps stability

Inflation is a problem and central bank policy has become singularly focused on one goal: lowering inflation. Central banks are contracting their balance sheets and using policy rate hikes to tighten financial conditions, slow domestic demand and thereby reduce inflation. This strategy has transformed central banks from a source of stability for markets to one of volatility. As long as high inflation lingers, we do not expect a change in Fed behavior anytime soon. The Fed is likely to stay the course until inflation nears its 2% goal. There is no guesswork here. Chairman Powell has clearly articulated the risks of ending the tightening cycle prematurely, often invoking the mistakes of Arthur Burns’ Fed tenure in the 1970s. We thus expect this market volatility to continue.

As we wrote earlier this year, liquidity reduction and tightening credit conditions amplify the pockets of stress beneath the surface. This is particularly true as growth slows. While the Fed has not yet brought inflation under control, we believe that it will ultimately prevail, even though it will likely engineer a contraction in domestic output. We are already starting to see evidence of weakness in the housing market and the manufacturing sector, two of the more interest rate-sensitive parts of the economy. We are also seeing the stark and unintended consequences of liquidity contraction in other markets, such as the UK government bond market. Monetary policy does not take effect immediately so it is likely the Fed will have to tighten at least a tad too much before it sees the impact of its policy maneuvers. The interim period of time during which economic stress joins tighter liquidity will likely result in many great market opportunities. But we are not there yet and must proceed with caution for now.  

A wild ride in the rates market this year

The volatility of this past year has predominated in the rates markets. We entered 2022 with expectations of a modest rise in rates as the Fed planned to reverse the easy monetary policy of the pandemic. Inflation was elevated and the market expected the Fed to take action gradually because it believed that higher prices were transitory and not as sticky as they turned out to be. As inflation data remained stubbornly high month after month, the Fed instead raised short-term rates aggressively at successive meetings. Figure 5 illustrates how quickly markets re-priced the Fed Funds rate as market participants understood that inflation would not budge easily. As of 12/31/21, markets priced in a Fed Funds rate of 0.82% by the end of 2022. As of 9/30/22, that projection surged to 4.24%.

Figure 5: Implied Federal Fund Rate by quarter

Source: Bloomberg. Forecasts may not be realized

Rates volatility has expanded beyond the US. In September, the UK government bond (Gilt) market experienced a remarkable swing in prices as investors reacted to the UK fiscal expansion program (the “mini-budget”), which exemplifies how sensitive the market is to any change in debt dynamics. Thirty-year Gilts moved 150 bps (Figure 6) in the course of a week, rivaling moves by emerging market economies during the depths of a crisis.

The rapid increase in UK government bond yields has caused significant problems for UK pension plans. Pension plans in the UK often use derivatives such as futures and interest rate swaps to increase the duration of their plan assets to match their liabilities. Rapidly rising yields have created significant losses on these derivatives positions, forcing plans to sell bonds to meet margin requirements for more collateral. This led to the emergence of a vicious cycle of selling bonds into ever declining markets. The sell-off, while centered on the UK Gilts market, reverberated through other markets until the Bank of England stepped in to buy long-dated Gilts in order to end the immediate crisis and stabilize the markets.

While some of the drivers of this crisis are UK-specific factors, this situation highlights the vulnerability inherent in a heavily indebted financial market when a price insensitive buyer, e.g., a central bank, turns from a buyer to a seller. We expect more sources of volatility to emerge in the coming weeks and months.

Figure 6: 30-Year UK Gilt yields

Source: Bloomberg.

Portfolio positioning and beacons of hope

We have spent the year building liquidity across strategies, upgrading the quality of our risk across the board and taking advantage of small pockets of value as they emerge. With Treasury yields as high as they are, there is less need to extend out the risk spectrum, particularly as the US economy is likely to enter an economic recession in the coming months. Instead we prefer to focus on three areas of the market that offer value: 1. short maturity investment grade corporate bonds, 2. agency mortgage-backed securities, and 3. municipal bonds. By positioning our portfolios in favor of these investments, we retain ample liquidity to quickly deploy as we identify attractive opportunities. This is the advantage of a multi-sector fixed income portfolio. 

  1. Corporate credit markets have considerably underperformed this year, though spread changes have not moved in a straight line. Markets have been volatile with prolonged periods of widening followed by shallow but sharp rallies. As of 10/13/22 data, investment grade corporate spreads are slightly cheap relative to their historical averages, clocking in around the 93rd percentile versus their 10-year range (93rd is only reasonably cheap as the move from 93rd to 100th over the last decade was 100 bps whereas 50th to 93td is only 40 bps). While spreads are clearly more attractive than they were a year ago, they are not yet at recessionary levels so we advise that investors maintain some caution.  

While we expect spreads to continue to widen, we are cognizant that the fundamentals in the credit market are relatively robust headed into this macroeconomic downturn. Leverage metrics are moderate and there appears to be some cushion before moving into a downgrade cycle. In fact, we struggle to see the excesses on a sector level that we typically see headed into a downturn (e.g., energy in 2015, housing/financials in 2007-2008). It is usually those sector imbalances that cause the majority (about 60%) of downgrades, with the rest resulting from the cyclical downturn in earnings across sectors.  

Historically about 14% of BBB-rated corporate bonds are downgraded into high yield during a typical recession but research suggests that the downgrade wave this time could be limited to only about 4% of issuers, thanks to better fundamentals and fewer sectoral imbalances than in past cycles. It is therefore reasonable to expect that this cycle does not see the traditional widespread levels experienced in past recessions but instead a more modest widening.

Fortunately, in our view, the best opportunity in corporate credit is in the least “risky” corner of the market: within short maturity investment grade bonds, where we are obtaining yields north of 5% (Figure 7), the majority of which is now derived from elevated government bond yields as opposed to spread. This is in contrast to 2020 and 2021, when rates were at depressed levels. With credit curves flat, there is little need to buy longer maturity corporates with high degrees of spread sensitivity, especially given our view that credit spreads will continue to widen. Short-dated bonds will be relatively insulated from such moves, given their low sensitivity to  price changes and the high degree of income that they generate. We do believe that there will be a great opportunity to add higher credit risk over the coming months but we are not there yet. 

Figure 7: ICE BofA 1-5 Year US Corporate Index Yield: broken down into components

Source: ICE. Shown for illustrative purposes only. There is no guarantee current performance trends will continue.

  1. Another area of the market that has become more attractive recently is the securitized sector, particularly agency mortgages. This is a AAA-rated sector with an implicit government guarantee and as such, there is no credit risk, only convexity risk (i.e., the risk of prepayments or extensions). Therefore the time to buy agency mortgages is when both volatility and spreads are high - as they are today. The mortgage market was quite concerned with the notion of the Fed converting from the largest buyer of agency MBS to a net seller; spreads have widened quite aggressively (Figure 8). The sector has deeply negative excess returns this year — comparable to the investment grade credit market - a very unusual result given the disparity in ratings; agency mortgages are rated AAA whereas the US IG corporate market is rated A-. We have been steadily adding to our exposure to agency mortgages, preferring the liquidity and spread here as compared to the corporate market.

 Figure 8: Bloomberg US MBS Index: OAS and excess return YTD

Source: Bloomberg. Shown for illustrative purposes only. There is no guarantee current performance trends will continue.

  1. Yet another emerging opportunity lies within the municipal market. Tax-exempt municipal bonds tend to attract tax-paying investors who are more sensitive to total returns. When fixed income produces deeply negative total returns, as it has this year, the sector is sold indiscriminately. After a year of historic inflows in 2021, outflows this year are the worst since the data has been collected (1993), with over $95bn out year to date (Figure 9). As a result, the sector has undergone a significant re-pricing despite improving municipal fundamentals. In our view, the sector has now cheapened enough to make it attractive even for non-tax paying investors. Additionally, it has the benefit of less exposure to the economic cycle than other credit sectors. We are also considering taxable municipal debt, which has suffered this year and looks attractive relative to long-dated corporates, offering an appealing combination of cheap valuations, high quality and diversification in times of economic stress.

Figure 9: Municipal flows (in billions) reversed course in 2022 as rates rose

Source: Lipper as of October 5, 2022.

Higher quality fixed income  - opportunity on the horizon

Fixed income markets have undergone historic drawdowns over the course of 2022 and haven’t provided the ballast many investors expected. The challenges the market has faced are staggering but we can all take heart in future opportunities. We believe that fixed income now offers a singular opportunity for longer term investors seeking attractive absolute yields, diversification and total returns. As the economy hits the brakes and inflation crests, we believe the opportunity is considerable. However, in this market, patience is the name of the game. Opportunities will continue to present themselves as the tide of liquidity continues to recede. Valuations have not yet justified a bullish stance across broad credit markets but we are waiting on the sidelines with liquidity. As always, we remain patient and poised to pull the trigger when opportunities materialize.

Important Information

The material is not intended to provide, and should not be relied on for accounting, legal or tax advice, or investment recommendations. Information herein has been obtained from sources we believe to be reliable but Schroders Plc does not warrant its completeness or accuracy. No responsibility can be accepted for errors of facts obtained from third parties. Reliance should not be placed on the views and information in the document when taking individual investment and / or strategic decisions. The opinions stated in this document include some forecasted views. We believe that we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee that any forecasts or opinions will be realized. This document does not constitute an offer to sell or any solicitation of any offer to buy securities or any other instrument described in this document. Past performance is no guarantee of future results.