13 Aug 2021
Fixed income markets have been sending a notably more bearish signal than global equities over recent months. We discuss how this tug of war is likely to play out from here and outline the importance of focusing on the three “Ds” - due diligence, discipline and diversification - when it comes to credit selection in the current environment.
Tug of war might not be contested as an event at the Tokyo 2020 Olympic Games, but that has not deterred fixed income and equity markets from pulling in different directions of late.
S&P 500 index price vs. US 10-year Treasury yield
On the one hand, government bond markets have been flashing a warning signal to investors, with core government bond yields falling back to levels last seen in February 2020. This feels like confirmation of the trend that has been in place since March, with capped or falling nominal yields, fully priced breakevens and very low real yields.
On the flip side, global equity markets have, on the whole (with the exception of China), so far shrugged off Delta variant concerns and seem comparatively more relaxed, surging to new all-time highs in July.
Why have fixed income and equity markets been sending investors different signals? We believe bond yields have fallen due to a mix of fundamental and technical factors. This includes concerns about the trajectory for economic growth, markets moving to price in a lower expected peak for the next interest rate hiking cycle, as well as investors backing out of short positions in US Treasuries.
Contrast this to the mood in equities, where the broad view seems to be that loose monetary policy coupled with strong corporate earnings growth is sufficient to prop up risk-on sentiment. The buy-the-dip mentality among retail investors is still very much in play too, serving to ensure recent pullbacks in major equity indices have been short-lived.
It will however be interesting to see if the volatility in Chinese tech stocks tests this reflex. For now, while we share some of the more bearish concerns, we are inclined to think the duration rally has overshot a little in the short-run and have trimmed nominal duration to 5.8 years in the Fund.
While the competition for sentiment ensues, high quality credit markets have hardly flinched and continue to trade in a tight range. Global investment grade (IG) credit spreads have traded in a modest range since mid-June (at the index level). We have seen a bit more widening in high yield (HY) and emerging market (EM) corporate debt markets over the equivalent period, albeit modest in a historical sense and masked in total return terms by the duration rally.
The notable exception has been in Asian HY, where a more meaningful sell-off has been driven by negative headlines in the property sector. However, weakness does though seem to be concentrated in a limited set of names and there have been few signs of contagion feeding through to developed markets.
Broadly speaking, we are sticking to our modestly positive view on credit, with a preference for IG credit over HY. While there appears to be limited scope for much spread compression in the near-term, we do not anticipate spreads moving meaningfully wider either. For as long as the low interest rate environment persists, investors’ thirst for yield should also continue to underpin demand for credit assets.
Given our range-bound expectations for credit spreads, we believe outperformance will be predicated on bottom-up single-name and instrument selection. We continue to selectively participate in new issues and trim positions where our theses have played out or changed entirely. Overall, due diligence, discipline and diversification will drive our credit positioning from here.
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. Investments in emerging markets can be more volatile than in other more developed markets. The Fidelity Strategic Bond & Sustainable Strategic Bond Funds can use financial derivative instruments for investment purposes, which may expose it to a higher degree of risk and can cause investments to experience larger than average price fluctuations. 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.