It’s a new dawn, it’s a new day

Read this article to understand:

• Key factors contributing to uncertainty in global credit markets  
• What makes investment-grade credit attractive on a risk-adjusted basis 
• The challenges caused by quantitative tightening

After more than a decade of bond buying by major central banks, which bolstered sentiment and supressed yields, the impact of inflation and rapid interest-rate increases are reverberating through financial markets. The disappearance of cheap borrowing has already taken down high-profile names and prompted investors to question what will happen when central banks trim their balance sheets with greater vigour (see Fragilities exposed as cheap money disappears).¹

In this higher inflation, higher rates world, some trading strategies that proved successful in the past are unlikely to be so in the future. In this Q&A, James Vokins (JV), global head of investment-grade credit, and senior portfolio manager Chris Higham (CH) discuss how they are positioning for the new market regime.

Yields have moved significantly – how does IG shape up against other risk assets?

JV: At the beginning of 2023, we were constructive on investment grade (IG) relative to other fixed-income asset classes. In an economic slowdown, high-quality fundamentals should outperform low quality. The spread premium for IG looked attractive and yields were as high as they have been for a decade.

While we were conscious higher yields were also available in government bonds, we did not believe we were at the end of the cycle yet and still felt there were better risk-adjusted returns available in IG. And, other than selective opportunities, the yield pick-up in high yield (HY) relative to IG was not compensation enough for the credit and default risk. We have become accustomed to receiving two-to-three times more yield from owning HY than IG. In this case, an investor would be getting less than double.

We were not expecting it to be a strong year for spread tightening because of vulnerabilities in the market and further rate hikes. Our structural view is for spreads to be wider over the longer term, but heightened  volatility is likely to produce some short-term opportunities. Equally higher yields are offering more of a cushion against volatility. In other words, even in a modest spread widening environment, positive total returns can be delivered. IG has more duration than HY, so there is a natural hedge if recession fears accelerate and a flight to safety picks up.

At a sector level, where do you see the greatest opportunities and risks?

CH: We are cautious of the impending slowdown instigated by central bank tightening. We think it’s likely to prove challenging for most sectors. There are, however, non-cyclical areas we like including technology, media and telecoms (TMT) and utilities.

In an environment where growth is slowing and there is the potential for recession, the focus is on not owning the things that go wrong: not holding Credit Suisse Additional Tier 1 bonds (AT1s, a form of contingent convertible) or debt issued by SVB Bank, and so on. For credit investors, avoiding the losers is always more significant than trying to pick winners, but even more so now.

In January, we would have said financials were likely to benefit from interest-rate rises. Certainly, from an earnings perspective, we have seen US money centre banks reporting strong earnings on the back of them. But, of course, the big risk episode of the year has been in financials. 

JV: Banks make up about 25 to 30 per cent of IG and a smaller part of HY. In our view, the issues with financials are contained within a few US regional banks rather than the large money centre institutions we own.

SVB failed, and now First Republic Bank has been taken over. Needless to say, these are significant events, but it’s worth noting the overall exposure in the debt markets of these credits, and regional banks in general, is small. SVB only made up around 0.03 per cent of the global IG benchmark while First Republic only had subordinated bonds in HY. We do not expect that to be the end of the matter. There's potential for more ripple effects throughout the US regional banking sector.

The situation with Credit Suisse was triggered by what happened at SVB, although Credit Suisse had well-recognised problems. It was losing money every quarter and giving earnings warnings repeatedly. While it is significant to witness a global systemically important bank fall over, our view is that there is slightly better capital and liquidity strength in European banks. We are comfortable with our modest overweight and do not see Credit Suisse as indicative of another long-term systemic issue.

In terms of losers, real estate has been the worst-performing sector. It is the area of most concern both directly but also for those exposed to the sector, whether they are life insurance businesses or banks. Clearly there are ongoing structural pressures in the retail and office markets and questions over residential property too.

How have your allocations changed from a year ago?

CH: We are overweight higher-quality credits. Within financials, we started the year with a large overweight, then went into February modestly overweight. That hurt us initially, but since then performance has come back through adding higher-quality names.

JV: We reduced HY exposure by trimming a riskier component in subordinated financials, part of our strategy of reducing overall banking exposure. Fortunately, most of that was completed prior to the issues that emerged in March. We have also increased exposure to safer assets – high quality AA- and single A-rated bonds, and more Treasuries.

We have concentrated the global IG portfolio into fewer holdings and are trying to differentiate winners and avoid losers rather than trying to make excess returns from dialling up beta. That was the way to trade previously; in the last decade, whoever had most carry generated the most excess return. Conditions are changing and that strategy is unlikely to work as well in future.

It means we must be more attuned to specific idiosyncratic stories that do not correlate so much to beta but can still generate outperformance regardless of market direction. It is all increasingly about stock selection, name concentration and conviction.

What's changed on the inflation and rates outlook?

JV: Higher interest rates have exposed vulnerabilities, making the landscape more challenging for central banks to navigate. We believe they will target inflation over financial stability in the longer term, but there is more to do in the short-to-medium term to ensure the smooth running of financial markets.

The banking issues in March led the rates curve to move lower as everyone priced in a stress scenario, bringing forward the likelihood of further rate cuts and lower growth and inflation. The consensus has shifted to a more cautious stance and interest-rate cuts towards the end of this year. It is clearly difficult to try and pin down an end-of-year view, but our base case is that this is still too soon for cuts. Longer term, we think there are structural forces at play that may ensure inflation is sticky and rates will end up modestly higher from here, closer to “normalised” levels within fixed income.

Regional differences have also intensified. At the beginning of the year, market moves were close to the same order of magnitude in Europe and the US. It now feels as if the US is a little ahead, with inflation starting to soften, or some cracks appearing in certain sectors. In Europe, inflation is still quite strong and there may be more to do by central banks. These nuances are making things more interesting from a cross-currency perspective.

Broadly, our views on inflation and growth are constant reminders of the stresses in the market. This is still the early stage of a new dawn for fixed income and markets in a higher inflation, higher rates world. We do not want to get complacent about assuming things will go back to where they were.

Are you concerned about the step-up in overall indebtedness?

CH: We spend more time on this than anything else, particularly what it means now the regime that put downward pressure on yields has begun reversing. The cost of money globally has quickly gone from around zero to five per cent, which will take a while to work through. In the process, we will find out exactly who has been doing the things they should have been doing and vice versa.

Markets are grappling with major questions and that is why there is a struggle to price assets. Inflation is close to a 50-year high, there are big questions about demographics and structural changes in labour markets, and we are grappling with the green transition and geopolitics. All these things play a part in what is happening and why we think inflation is likely to persist.

Inflation is a comparatively easy way out of the high-debt scenario, and it’s one we have been contemplating for three or four years. That takes us back to when we first put inflation protection into our funds – at a time when it was not being priced more widely. We are mindful of the turning points and likelihood things may be volatile while the issues work through.

JV: But the issues are hard to pin down and monetise. Timing is key. There are ways we can protect downside longer term while still benefiting from tactical positioning, but, speaking broadly, investment horizons may be shorter term. If you constantly run the same long-term view and never change, you run the risk of missing opportunities. We must always come back to solid ground, as there is a lot of debt out there. We need to be mindful exactly where it is – in governments, corporates and households.

The Fed is trying to improve liquidity in the Treasury market by expanding the number of market makers. Could this have any knock-on effects?

CH: At the start of 2022, we were more concerned about quantitative tightening (QT – central bank balance sheet reduction) than rates going up. Central banks had never experienced these situations before, so it was hard to know what the impact was going to be.

Liquidity can come and go quickly, and we need to be sure we have a chair to sit on when the music stops. Things have changed a lot since the financial crisis – risks have changed. Nevertheless, we are more confident now about the health of the financial system: leverage is not at levels seen in 2006, 2007 and 2008.

Changing the list of market makers will not significantly alter the situation. Each new player with some balance sheet will help marginally, but it is unlikely to make a difference overall unless there is a significant change in regulations. 

The US believes in free markets and people being able to lose money, make money and lose it again. That is why it feels as if they lurch from one crisis to the next. In Europe, there is more oversight and intervention, and you tend not to see the same kind of excesses.

JV: That brings us to an interesting question about what we could see on the regulatory side after the SVB failure. That situation is fairly contained, given its deposit base was quite monoline and there are few business models like it. That said, there needs to be better regulation around the speed at which deposits can leave a bank in a world where so much banking activity is online. Bank stress tests have shored up capital, but not so much liquidity. There is more liquidity regulation needed, which will come at a cost to earnings.

No bank wants to be losing deposits in this kind of scenario, so there is likely to be greater competition for deposits. It is interesting to see how much deposit flight came from SVB into the big banks like Bank of America and JP Morgan, then was reinvested in money market funds by savers looking for higher rates. The average deposit rate offered by the larger banks is around one per cent in the US against about five per cent in money market funds: you can obviously get a significant uptick from low-risk money market savings accounts.

Will recent market turbulence put QT on hold?

JV: Central banks acted quickly to address financial stability and there may be more to do in the short term. Longer term, they still have a job to do on inflation and unwinding their balance sheets, which I think they will continue to do, but that is just not the focus for now. I expect it back in the coming months. We have the US debt ceiling issue coming up in the summer as well.

Beyond that, QT is likely to be part of the toolbox and something central banks wish to continue with, providing markets allow it. The impact is yet to come through. We’ve never experienced QT to the extent we are likely to in the next phase, which adds to the reasons to be cautious.

At the moment, the UK is the only country where corporate bond QT is ongoing (see Figure 1). The process is going better than we anticipated so far.

Figure 1: Unwinding UK corporate bond purchase scheme (£ billions)

Source: Bank of England, April 28, 2023²