30 Nov 2021
Against a more challenging macro backdrop for risk assets, we believe spreads are likely come to under pressure next year. Having said this, we are not expecting a meaningful gap wider given growth will still be significantly higher than pre-Covid-19 levels.
The underlying theme for credit in 2022 is likely to the decompression trade. Higher beta sectors could experience greater volatility, while concerns on the higher quality part of the part, which has been under pressure on duration concerns, will subside.
In keeping with the broader trend in global credit markets, we still see scope for rising stars in sterling credit which could be an attractive opportunity. Given this, our focus is on alpha, rather than beta, looking to 2022. With regards to issuance, we see greater supply of green, social and sustainability bonds and this should be supported by the Bank of England shift to ‘greening’ their corporate bond portfolio.
While we expect rate rises in the UK, we expect this to be more modest than current market pricing and do not see this being enough to undermine fixed income.
Central bankers are now looking to tighten monetary policy and a communication error on this front remains a key surprise factor for investors in 2022. The Bank of England offered a preview of this potential risk after its November policy meeting when it caught the market off-guard by deciding not to raise rates. This caused a bout of volatility in the short-end of the market, with two year Gilt yields falling 0.2% on the day. This was largest daily fall in two year Gilt yields in this millennia outside of Brexit, the Global Financial Crisis and the Covid-19 induced sell-off in March 2020 and it simply came following an MPC meeting.
We think rates volatility is likely to remain in 2022 and if investors are concerned about this, they may want to consider adding to short dated corporate bonds.
Credit spreads are tight and the beta compression trade is firmly over. As such, we think investors need to focus on areas of the credit market that offer an income pick-up with an element of safety at the same time, rather than via traditional risky sources that look priced for perfection.
Two areas meet this need in our view. Firstly, the asset-backed sector (ABS) continues to offer an income pick-up over straight corporate bonds and these bonds benefit from being secured on assets or income streams. We believe this is a good way to navigate the uncertain economic backdrop that lies ahead. ABS also have a diverse range of underlying economic exposures, such as the auto-recovery sector (such as the AA and RAC), infrastructure assets (such as Channel Link which is secured on the channel tunnel) and property (like bonds secured on the Westfield shopping centre), among others.
Secondly, we continue to find value in certain Covid sensitive areas that trade wider than the broader market. The areas most sensitive to the fall-out of the Covid-19 impact are leisure, travel and infrastructure assets. We see value on a single-name basis in these areas but have taken a very select approach. Framing our appetite is looking to how companies have adopted self-help measures such as raising liquidity, via equity or debt (or both) and have skewed to domestic, rather than international, re-opening trades.
We fail to see how the Bank of England can hike four times to 1% over the next 12 months as the market is currently pricing. We think 0.5% is a more realistic peak before the bank pauses for breath. Therefore, cognisant that duration supports a low correlation with equity markets - which is an attractive quality given valuations in risk assets - we are happy to hold some duration.
The beta compression trade is firmly over and we think traditional sources of beta, like banks and high yield more broadly, may warrant caution and we are upping the credit quality in the portfolios. Single-name selection will be paramount in 2022.
There is no doubt that sustainability is increasingly becoming an important lens through which to navigate risk and opportunity in the corporate bond market. We only need to look to tobacco names in the sterling credit space as evidence of this as investors have shunned the sector causing underperformance in spread terms. Ultimately, we are long-term investors focused on capital preservation so assessing risks, like climate risk, need to be part and parcel of the investment process to consistently generate alpha and protect on the downside.
We aim to deliver investors a balance of the three-pillars of bond investing, namely a balance of income, downside protection and diversification away from stocks. As such, we adopt an approach that tends to be defensive in nature by focusing on high quality investment grade corporate bonds issued by companies we think are likely to stand the test of time. Naturally, this means we tend to bias to issuers that exhibit superior sustainable qualities.
Important information
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of investments in overseas markets. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Due to the greater possibility of default, an investment in a corporate bond is generally less secure than an investment in government bonds. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes.