Invesco: Fixed income investment outlook: a promising year after a painful selloff

Bond investors are “the vampires of the investment world”, according to American investor Bill Gross. “They love decay, recession – anything that leads to low inflation and the protection of the real value of their loans”.

If that’s true, then 2022 has been a metaphorical stake to the heart. High inflation and a string of rate hikes have resulted in a bruising year for the asset class. Central banks have scrambled to cool economies on the back of supply chain disruption, a war in Europe and rising energy costs. As a result, yields have soared to their highest levels in a decade, resulting in some heavy losses across bond markets.

The silver lining of all of this is the return of income in fixed income markets, which had been largely missing in action since 2008. Equity-like returns can now be found in some parts of the asset class. There has been a lot of interest from investors looking to allocate to fixed income going into 2023. This has only been exacerbated by talk of an impending recession.

Macroeconomic backdrop

Speaking to our fixed income investors across Invesco, the general consensus is that inflation is near its peak, if it hasn’t peaked already. Supply chain issues are largely resolved, inventories are building up, and spending will likely fall as rises in the cost-of-living weigh on the consumer.

Moderating inflation would allow central banks to soften their stance, and some of our fixed income teams are suggesting that interest rates could peak in the first quarter of next year. But it is notoriously difficult to predict a Federal Reserve (Fed) pivot. Investors will be watching the data closely so that they can respond.

"We do not know exactly when the Fed will pivot from raising interest rates, but it’s likely to be driven by inflation, so any sign of improvement there could trigger a shift in investors’ risk appetite." 

Paul Syms, Head of Fixed Income ETFs

Without pause for rest, the conversation is now evolving to incorporate concerns about slowing growth and recession. The path to a soft landing is narrowing and, as soon as the pendulum swings from inflation to negative growth, fixed income is where many investors will want to be.

Fixed income 101: Why are bonds attractive in recessionary periods?

Bonds typically outperform other assets (for example equities) in recessionary periods, as they are seen to be safer assets. As such, many investors rush into bonds in what we call a “flight to safety”. This pushes their prices up.

Furthermore, governments often lower interest rates in recessionary periods to encourage spending. This pushes bond prices up, as the fixed coupon payments start to look attractive relative to falling interest rates.

Where do we see opportunity?

With spreads having widened materially in 2022, the choice between fixed income asset classes is now more crucial than it has been for some time. Against this backdrop, how should investors construct their fixed income allocation? We share our insights on different areas of the market.

Outlook for government bonds

The rise in yields over the course of the year has meant that government bonds are now offering attractive levels of income. For example, the 10-year Treasury yield is now just over 4%, versus 1.5% at the start of the year and 2.6% as recently as early August.  

With recession the most likely scenario heading into 2023, government bonds would generally be expected to fare well. This is because they’re usually supported by more accommodative central bank policy and “safe haven” buying. That historical behaviour may be repeated if uncertainty persists around inflation and interest rates.

Outlook for investment grade credit

Credit spreads have widened significantly this year and, outside of crisis periods like 2008, have rarely been wider than they are today. This is creating good income opportunity for corporate bond investors. Indeed, it is worth remembering that the spread on corporate bonds is paid over the government bond yield. Government bond yields have also risen considerably over the course of 2022, making overall yields very attractive.

Of course, it is important to remember that wider spreads reflect an increased level of credit risk as we navigate a challenging macroeconomic environment. However, today is not like previous crisis periods. The banking system is secure and well-capitalised and companies have been relatively cautious in their approach, building up balance sheet strength. 

"The risks this time are not systemic. That gives us confidence to buy corporate bonds whose yields are now 4-6% in many cases." Michael Matthews, Co-Head of Fixed Interest

There could be pockets of regional opportunity, as shown in the below chart. Spreads have widened¹ more in Europe than the US as a result of the ongoing war in Ukraine, greater sensitivity to the energy crisis and heightened growth concerns. Given that corporate fundamentals remain robust with downgrade concerns well contained, these markets could prove attractive.

"We believe European spreads are offering good value here, especially relative to the US, compensating investors for the weaker growth outlook." Lyndon Man, Co-Head of Global Investment Grade Credit

Figure 1. IG credit spreads: regionally there is a lot of dispersion

Source: Invesco as of 26 October 2022.

Outlook for high yield and subordinated debt

The high yield market is now living up to its name. Yields in the asset class are higher than they have been for a long time. This is creating opportunities for investors who are willing to increase the risk profile of their portfolios. 

"For riskier bonds such as high yield and subordinated bonds, yields are in the high single digits." Thomas Moore, Co-Head of Fixed Interest

The risk for this asset class is that economic weakness could lead to credit stress and defaults. Thorough credit analysis will be important in allowing investors to selectively favour companies with balance sheets strong enough to weather the storm.

Additional Tier 1 contingent convertible bonds, often referred to as AT1s or CoCos, might be an interesting segment for investors looking to increase risk in search of higher yields. These hybrid securities are issued by European financial institutions and act as a readily available source of bank capital in times of crisis. 

"We believe yields on AT1s are currently attractive both outright and relative to traditional high yield, and any signs of an end to central bank rate hikes should be a positive for the market." Paul Syms, Head of Fixed Income ETFs

We share a case study from our Investment Grade Credit team, who are also finding select areas of opportunity in subordinated debt.

Case study: Finding select opportunities in subordinated debt

Lyndon Man, Co-Head of Investment Grade Credit

We think that there are attractive opportunities to invest in the subordinated bonds of well-capitalised European banks and corporates. Several factors underpin this:

• The risk-off / rising rate environment has resulted in a systematic cheapening of this part of the market. This has created attractive risk-reward dynamics, in our opinion.
• European banks continue to improve their balance sheets post-Covid. Furthermore, rising interest rates will help to improve their profitability.
• Corporates remain committed to this part of the market (corporate hybrids) given cost of capital considerations. As such, we believe the extension risk is more muted than is currently priced in.  

We remain very selective with a focus on core, high quality investment grade issuers.

Figure 2. Subordinated bonds offer good value versus their senior counterparts

Source: Invesco as of 26 October 2022.

Outlook for emerging market debt

US policy and rate developments will be influential in shaping the outlook for emerging market debt – something that investors will be watching closely. 

"We believe that a reduction in US rate volatility, as opposed to the absolute level of interest rates, is critical for sustained performance in emerging markets." Wim Vandenhoeck, Senior Portfolio Manager, Global Debt

Figure 3. The problem for markets is the dollar, and the challenge for the dollar is US rate volatility

Source: Bloomberg as of 14 October 2022.

While there could be volatility over the next few months, the opportunity in EM local debt over the medium and long term looks significant. Several factors underpin this:

• Inflation is starting to moderate in some developing regions, namely Latin America and pockets of Central and Eastern Europe (CEE).
• The value created from an absolute income and return perspective has been meaningful.
• The environment of widespread idiosyncratic country news stories and return dispersion provides a fertile landscape for active managers to extract performance alpha in the asset class.

What are the main risks?

Runaway, unanchored global inflation and a deep protracted recession are the main risks for the asset class. Untenable inflation would force central banks to continue rate tightening, putting pressure on absolute rates while further restricting financial conditions and ultimately growth. Similarly, a sustained global recession and “flight to safety” investor behaviour would also be disruptive.

Outlook for senior loans

While there are questions around the Fed’s policy to increase rates, with an increasing number now arguing that inflation is reaching its peak, the market still expects at least another 150 basis points of rate increases before a levelling off in 2024.

Higher interest rates would drive higher levels of income for senior loan investors, due to the floating rate nature of the asset class.

"We expect coupons to continue to increase as a hawkish Fed attempts to quell inflation." Kevin Egan, Senior Portfolio Manager, Senior Secured Bank Loans

If the Fed continues to raise interest rates, investors may start to become concerned about issuers’ ability to service their debt. However, as highlighted in the below table, the average borrower has entered this cycle in a strong position. Interest coverage ratios at the end of 2021 were near their highs, leaving companies with sufficient ability to absorb higher interest expense. 

Figure 4. Interest coverage peaked at healthy levels, but set to decline as rates rise

Source: LCD Pitchbook as of 30 September 2022.

Furthermore, as the world braces for a recession, the senior secured status of this asset class could leave it looking more attractive to investors than other high yielding asset classes. Indeed, senior loans are secured to underlying collateral, which means they are the first part of the capital structure to be repaid in the event of a default. While defaults are still very low, the secured nature of the asset class has translated to higher historical recovery rates (60-70%) compared to other subordinated asset classes. 

Footnotes
¹A credit spread is the excess yield that one security offers relative to another. Typically, when spreads widen (in the context of fixed income bonds), it indicates worsening economic conditions.

Investment risks
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

Important information
Data is provided as at the dates shown, sourced from Invesco unless otherwise stated.

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Where individuals or the business have expressed opinions, they are based on current market conditions. They may differ from those of other investment professionals. They are subject to change without notice and are not to be construed as investment advice.