Invesco: Fixed income: Our review of 2022 and 2023 predictions

Key takeaways

In a tough year, with terrible returns across the bond market, we were able to reduce the negative impact on our fund’s returns by taking a defensive position.

We’re more positive than this time last year. Rates are higher and growth is lower but, crucially, yields are higher and we think valuations are better.

In 2023, with the right mandate of being flexible, broad and downside-aware – we’re confident we can navigate varying market conditions.

After an eventful year filled with market volatility, Stuart Edwards, Fixed Interest Fund Manager, shares his thoughts on the performance of the Invesco Tactical Bond Fund (UK) in 2022. We also look to 2023 to see how market conditions may impact the fund going forward.
 

How would you assess the performance of the fund in 2022? Are you pleased with how it has done?

I’m pleased and displeased. It’s never good to see our clients losing money and the fund is down. Returns were terrible right across the bond market in 2022. Inflation pushed rate expectations up fast, so sovereign bonds were hit hard. But credit risks increased as the outlook for growth deteriorated, so spreads moved wider too.

On the other hand, I’m pleased that we were able to reduce the negative impact of these market moves on the fund’s returns. We came into the year positioned quite defensively, with a lot of liquid assets and close to zero duration. That was a big factor in our relative outperformance. For the year, the fund (Z Acc share class) returned -4.6% compared to -12.0% for the IA Strategic Bond NR sector.  For standardised, rolling 12-month performance, please refer to the footnotes.

Other factors have helped over the course of the year too. But blunting the impact of the rise in yields in the early part of the year was a good start.

It was also a good year to show what we can do with this fund. Our mandate gives us a lot of flexibility and we always put an emphasis on being downside-aware and trying to achieve good returns on a risk-adjusted basis.

In periods when there isn’t much volatility, it can be hard to show the potential benefits of this approach. But, this year, we had plenty of volatility! Actively managing our investments and the level of risk in the fund made a difference. The fund’s longer-term risk-adjusted return (Sharpe Ratio) is one of the highest in the sector.
 

What would you say to an investor wondering if this is the time to be adding to fixed income?

I’m a lot more positive about the bond market than I was a year ago. As a bond manager, I feel like I’m always watching four things – inflation, central banks/interest rates, growth, and valuations. Looking through that lens, I think the market is in a much better place.

A year ago, inflation was lower than it is now, but interest rates and government bond yields were still near all-time lows. So, investors were not being compensated well for inflation or inflation risk. Now, inflation is higher, but the data suggests it’s close to or past its peak, at least in some economies. And on the other side, interest rates are a lot higher and so I think the balance of reward for risk is better.

Growth is weaker – that’s something to worry about when looking at credit risk, especially in the high yield market. But lower growth also puts downward pressure on inflation.

Lastly, valuations are much better. We’re getting paid a lot more yield. Government bonds yields are at or near the highest levels since before the financial crisis. Credit spreads are at the upper end of the last decade’s range. Yields of 3.5% for two-year gilts, >5% for sterling investment grade or 7.5% for European high yield bonds are a much more comfortable starting point for investors than the levels we had.

Figure 1. Sterling yields (ICE indices, effective yield, %)

Source: Macrobond, 31 December 2022

Of course, I don’t choose just to be in the bond market or not. Managing the Invesco Tactical Bond Fund (UK) is also about choosing where in the bond market to be and which risks to take. I can take duration risk, but I can also take that risk in different markets – that’s an important choice. Similarly, I see lots of good opportunities within parts of credit risk, but I don’t think just buying credit is a ‘slam dunk’.
 

Government yields, especially in the UK, got to high levels in the autumn but they have come back since. What do you think about interest rate risk now?

The volatility in the gilt market was a good opportunity and we did increase the fund’s duration, including through buying gilts. We took the modified duration of the fund to about 5.5.

We’re still quite positive about the yield you get paid for interest rate risk. But there’s been a pretty big rally back from the October peak. As well as the reduction in UK political volatility, this has been driven by falling interest rate expectations. Investors have taken heart from evidence that inflationary pressure is receding.

We think the market might be getting too optimistic on this front. We can envisage a scenario where stronger-than-expected economic data, maybe in the US, prompts a renewed sell-off. At the lower yields we have now, we’re less bullish, and we’ve reduced duration to about 3.3. We’ve cut exposure to US dollar duration in particular.

Figure 2: Active duration management (modified duration and contributions)

Source: Bloomberg, Invesco. Data to 30 November 2022. Contribution to duration: data prior to and including 30 June 2019 is sourced from Barclays Point. Excludes some categories. Please note the ICE BOAML Sterling Corporate Index is not a target, constraining or comparator benchmarks of the fund. The comparative information shown here is to illustrate the fund manager's active investment approach and provide broader market context.

Looking back over the history of the fund, you’ve always managed duration in a range from about -1 to +5. What would make you go outside that range?

We certainly can take duration higher than it has been in the past. I think it’s important to remember that we set up this fund in 2010 so, for almost all its life, we have been operating in a low yield environment. We’ve managed duration quite actively, but we haven’t had a lot of opportunities to get paid very well for interest rate risk.

As I mentioned, we could see government bond yields going higher again from here if growth surprises on the upside, or if inflation is stickier than investors expect. That move might be exacerbated by market concern about the higher level of supply in the sovereign markets, both from new government borrowing and central bank selling.

If we saw a sizeable sell-off, we might bring duration higher than it’s been before. That said, the Invesco Tactical Bond Fund (UK) is a fund with a big opportunity set beyond just duration. If government bonds got much weaker, there would probably be other parts of the market offering more yield too.
 

Do you think there are opportunities in the sovereign curves?

Yes, the treasury, bund and gilt curves are all quite heavily inverted. The market is pricing in a peak in the Federal Reserve rate sometime in the first half of 2023 and in the European Central Bank and Bank of England rates later in the year.

Further out on the curves, rates are being held down by expectations for lower growth. It’s interesting to think about steepening trades. The short end could come down if rate expectations fall. But maybe the curve could steepen through the long end rising. This could be the case if the market feels that growth will be stronger or that the fight against inflation will be harder. Either could make yields at the long end look expensive.
 

Where do you see the value in corporate bonds?

In the last couple of months, we’ve been buying corporate bonds, including during the volatility in September and October. In many cases, that was about taking advantage of attractive offer pricing on individual bonds, where our research made us comfortable with the credit risk. Taking a step back, we’ve been favouring investment grade and I would say, even after the recent rally, that’s an area where we’re well compensated for the risk.

We’ve reduced our exposure to corporate high yield. We can see some good individual opportunities there too. My colleagues who specialise in high yield are very excited about the prospects for the market. We’ve chosen to be a bit more cautious on corporate credit risk in this growth environment though. Within high yield, I’d also tend to favour more recession-proof sectors, like telecoms, and avoid more growth-sensitive sectors, like retail.
 

Outside corporates, what areas of credit do you like?

This is where I think our mandate and our team’s resources give us a nice advantage. The Invesco Tactical Bond Fund (UK) can go into a wide range of markets, and we can benefit from having good analysis on-desk.

The fund has a substantial allocation to subordinated bank debt. This isn’t new. We think that in general, the banking sector is in pretty good shape. It’s well-capitalised and with earnings supported by this higher interest rate environment. In fact, we held more in this area last year. We’ve seen several of our positions called.

But we have been buying here too. We’ve been pleased to participate in some Additional Tier 1 (AT1) deals from strong banking franchises that we know well, where coupons have been in the very high single-digit or even double-digit range. It’s been a while since we’ve seen those.

In emerging markets, our exposure is focused on a small group of local currency sovereigns. We favour countries that have been relatively aggressive in their monetary tightening, like Brazil and Mexico. They offer good yields (averaging 10% for the bonds we currently hold) and maturities are between 2025 and 2031 – so reasonably short.

Another attractive option within the corporate space is hybrid bonds. We’ve been adding here as we like the idea of taking the junior bond risk in a strong balance sheet to boost yield, rather than taking the outright credit risk of a weaker or more leveraged high yield issuer.

But, as with all our positions, we’re looking carefully at the issuers. Property companies issue hybrids, but we have very little exposure to them. 
 

What do you think 2023 has in store?

That’s a dangerous question to answer! Our job is to capture yields that look generous relative to the risks. You can see from the level of risk and the choice of risks in the fund where we think we are and what we think might happen.

We think that, after the big re-set in 2022, government bond yields are offering reasonable reward for interest rate risk. We think that the spreads available in parts of the corporate, financial and emerging debt markets are attractive. And, within all these areas, we’re working hard to find the best individual bonds to add value.

On the other hand, we still have cash and other low volatility assets in the portfolio. We could take more risk. There are parts of the credit market, like corporate high yield and more growth-sensitive sectors, where we are wary. A weaker growth and higher interest rate market could test some businesses in 2023 and beyond, and that could warrant higher yields on their bonds.

The important thing for us is that we have the right mandate – flexible, broad and downside-aware – to navigate these markets.

Past performance does not predict future returns. Source: Lipper. The UK Treasury Bills 3 Months is a comparator benchmark. Given its asset allocation the Fund’s performance can be compared against the Benchmark. However, the Fund is actively managed and is not constrained by any benchmark. Please note the IA £ Strategic Bond NR is not a target, constraining or comparator benchmark of the fund. The comparative information shown here is to illustrate the fund manager’s active investment approach and provide broader market context. Fund performance figures are inclusive of reinvested income and net of the Ongoing Charge and portfolio transaction costs. Benchmark figures are total return, in GBP. Sector average performance is calculated on an equivalent basis. As this share class was launched on 12 November 2012, for the periods prior to this launch date, performance figures are based on the Accumulation share class, without any adjustment for fees. Performance figures for all share classes can be found in the relevant Key Investor Information Document.

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.

The securities that the Fund invests in may not always make interest and other payments nor is the solvency of the issuers guaranteed. Market conditions, such as a decrease in market liquidity for the securities in which the Fund invests, may mean that the Fund may not be able to sell those securities at their true value. These risks increase where the Fund invests in high yield or lower credit quality bonds.

As the fund can rapidly change its holdings across the fixed income and debt spectrum and cash, this can increase its risk profile.

"The fund has the ability to make significant use of financial derivatives (complex instruments) which may result in the fund being leveraged and can result in large fluctuations in the value of the fund. Leverage on certain types of transactions including derivatives may impair the fund’s liquidity, cause it to liquidate positions at unfavourable times or otherwise cause the fund not to achieve its intended objective. Leverage occurs when the economic exposure created by the use of derivatives is greater than the amount invested resulting in the fund being exposed to a greater loss than the initial investment.

The fund may be exposed to counterparty risk should an entity with which the fund does business become insolvent resulting in financial loss."

The fund may invest in contingent convertible bonds which may result in significant risk of capital loss based on certain trigger events

The fund’s performance may be adversely affected by variations in interest rates.

The fund has the ability to invest more than 35% of its value in securities issued by a single government or public international body.

This communication is for Professional Clients only and is not for consumer use.

All data is as at 12/31/2022 and sourced from Invesco unless otherwise stated.

Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice. This communication is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities.

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