14 Dec 2022
Adam Darling, Investment Manager, Fixed Income
Adam Darling looks ahead to the prospect of bad economic news in 2023, but explains why he hasn’t been this optimistic about bond markets for years.
2022 was one of the worst years ever for global corporate bonds, as markets were hit by the double-whammy of high inflation causing central banks to rapidly increase interest rates, and concerns about recession. I’d say it’s a near certainty that we’re headed for a global recession in 2023; indeed I think we may already be in one and are just waiting for the data to catch up and confirm it. This could be an important transition in market narratives; from the over-stimulated inflationary post-Covid era to a story of lower growth, weaker profit margins and volatile asset prices.
As with any asset class, though, starting valuations matter for future returns. Bond prices have fallen a lot (yields are also now much higher than recent history), which means they start to look more attractive to us in terms of possible investment outcomes. Yields exist to compensate investors for potential risk, and, as the graphic below shows, over the last decade yields have rarely been higher than they are today (and even then, only for brief periods of time).
Note: A description of ‘yield-to-maturity‘ and how it is calculated can be found at the end of this article.
Historically, when yields have been as high as they are today, forward looking returns over the following 12 months have almost always been positive for bond investors. Against the backdrop of month-to-month market volatility, this is worth keeping in mind – although it must be emphasised that the past is no guarantee of the future.
For active bond investors, one of the advantages of difficult markets is that they make everything cheaper: you don’t need to take unnecessary risks in search of an appealing headline return – because the market has sold off enough that even bonds issued by stable, resilient companies are offering yields the likes of which investors could only dream of for most of the past decade.
Despite my underlying bullishness, I’m sure that 2023 will be far from plain selling for high yield bond markets. After all, yields are high for a good reason. The economic outlook is grim and that means more companies will default on their debt. This can feel like a scary time to be investing, so markets are right to demand more yield by way of compensation for putting capital at risk.
As active investors, credit analysis is a big part of our job: trying to understand what current bond valuations are telling us about the consensus view of the market, and assessing whether we think bond purchasers are being over- or under-compensated for the risk of holding a given bond. The detailed process of analysing individual companies to understand their strengths and weaknesses can often be undervalued when markets are rising, but is critical to delivering returns in tougher times.
Europe was at the crosshairs of a huge amount of bad news in 2022. Hit by inflation and slowing economic growth as much as anywhere else, the continent also suffered from proximity to the war zone in Ukraine and an emerging energy crisis as its reliance on Russian gas became suddenly exposed.
These remain material risks that cannot be ignored, but we’d argue that pessimism is already baked into European bond valuations and that Europe now presents a lot of opportunities for bond investors, if investment is done selectively: our preference is for the euro-denominated bonds of high quality global companies (which are not necessarily even headquartered in Europe).
In contrast, US bonds – especially the high yield part of the market – haven’t performed as poorly as bond markets elsewhere in the world and as a result US bonds now look relatively expensive to us. Given their outperformance, I would expect to see more pressure on US high yield bonds during the course of 2023 as the global economic reality hits home, so I believe caution is merited.
Major western central banks have started making noises that interest rate rises may slow or stop in early 2023. Frankly, given that I anticipate a global recession, which in itself will dampen inflation, I think we could see a rate cut or two before this time next year. This would be good news for bonds in general, in particular government bonds and investment grade bonds, although it could be less of a boon for high yield, which is naturally a bit less exposed to interest rate movements.
The bottom line is that I expect the economic news in 2023 to be poor, but that needn’t translate into another tough year for fixed income. In fact, at current valuations, I feel more optimistic than I have done for years that investors in fixed income could make attractive returns next year. But it won’t be smooth or easy, and active investors will need to make sure they do all their homework and invest smartly to identify the compelling opportunities that bear markets deliver.
Definition: Yield to maturity YTM) is the total return anticipated on a bond if the bond is held until it matures, expressed as an annual rate. This includes both the income from the bond, assuming the bond issuer does not default on its debt, and any capital gain or loss there might be when the bond matures. It is therefore a theoretical projection and not a guarantee. It is also different to the quoted yield of any given bond fund, which is typically expressed as an historic yield, meaning it is based on income payments already made in the previous year.
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