Active fixed income
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Global bond markets have had a tough six months, enduring their worst first-half of performance in over 30 years1. Facing a seemingly perfect storm of high inflation, rising interest rates and the outbreak of war in Europe, fixed income might not at first look like the best asset class in which to seek attractive returns right now.
But in fact, the performance outlook for bond markets has become markedly more favourable since the beginning of the year. And for active fixed income managers, the turmoil is opening up opportunities the likes of which have not arisen for a number of years.
Broadly speaking, the long-term outlook for global fixed income investors has improved since the beginning of the year. While some investors might be concerned about bond returns year-to-date, yields are now broadly above longer-term inflation expectations and over the long haul, higher yields mean more income for fixed income portfolios. Bonds have also started to behave once again as a stable hedge against equity risk after having spent most of the year correlated with risk assets2.
That for one is a good reason not to lose faith in fixed income. But when you drill down into the tens of thousands of individual securities that investors can choose from within the global bond market, the picture is arguably even more sanguine. Indeed, we believe that certain segments of fixed income offer more active opportunities than at any time in the recent past.
Investment-grade corporate bonds are a case in point. High-quality credit spreads have widened considerably as financial markets have gone on a tumultuous ride during the first half of 2022. However, this spread expansion has not been uniform across the whole global credit market.
For example, US and European corporate bond spreads have diverged significantly. US spreads have moved from below 100 basis points at the start of the year to around 160 basis points at the end of June3. However, in our view, current US market valuations—with spreads in aggregate about 25 basis points above 10-year averages—don’t yet fully reflect the full range of risks facing investors, although pockets of value do exist, particularly in the banking, pharmaceuticals and utilities sectors.
Meanwhile spreads in Europe doubled from 100 to 200 basis points during that same period and European valuations, by contrast, are very cheap, but there’s little dispersion across sectors and the region is in the crosshairs of a recession, with the spike in European natural gas prices a particular threat.
In both regions—for different reasons—an active approach based on bottom-up security selection and relative value can help unlock the idiosyncratic opportunities.
Emerging market (EM) bonds have had the hardest time of all in the first half, experiencing the worst performance during the first six months of the year of all fixed income sub-asset classes4. The recent rapid widening of credit spreads, rises in developed market interest rates and the strengthening of the US dollar have all weighed on EM debt markets. However, as a result, prices for EM bonds are now at their lowest levels in five years in US dollar terms5, and attractive entry points have appeared across the EM quality spectrum.
This development is the most supportive for distressed issuers facing the prospect of debt restructuring as it lowers bond investors potential loss from default; but it should also result in tighter spreads for healthier credits, as investors are required to put a smaller dollar amount at risk for each bond purchased.
Nevertheless, as always in EMs, an environment of heightened risk and volatility can put an active manager’s approach to portfolio construction and risk management under the microscope. Here again, an active approach rooted in genuine security selection across diversified sources is key.
The recent sell-off in fixed income has actually made us feel more constructive around the return prospects in investment-grade credit and EM debt markets than we have for a number of years.
It’s at times like these that investors most need the qualities they traditionally seek in fixed income - such as a source of attractive income, return and a diversifier against equity risk from global credit, and strong risk-adjusted returns from EM bonds. The caveat is that investors seeking active opportunities in these markets need to adopt a disciplined, risk-managed approach to security selection to avoid the risk of being exposed to large drawdowns.
1 Source: Bloomberg. Returns for Bloomberg Global Aggregate Index USD Hedged, as at 30 June 2022. The first-half 2022 performance is the worst since the inception of the index on 1 January 1990.
2 Source: Vanguard and Bloomberg. Between 31 December 2021 and 30 June 2022, the Bloomberg Global Aggregate Index USD Hedged had correlations of 0.077 and 0.058 to the S&P 500 and MSCI All World indices respectively. Between 30 June 2022 and 31 July 2022, these correlations were -0.086 and -0.140 respectively.
3 Source: Bloomberg, from 1 January 2022 to 30 June 2022.
4 Source: JP Morgan EMBI Global Diversified Index, as at 30 June 2022.
5 Source: JP Morgan EMBI Global Diversified Sovereign Total Return Index in USD terms, as at 30 June 2022.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Past performance is not a reliable indicator of future results.
Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.
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