M&G Public Fixed Income Team
A better starting point for bonds in 2023
Bond markets experienced one of their sharpest sell-offs on record in 2022, as concerns over persistently high inflation forced central banks to take a far more aggressive monetary policy stance, with the Federal Reserve pushing through a series of interest rate hikes. There were few places to hide in fixed income, as government bond yields climbed to their highest levels in over a decade, while credit valuations also came under severe pressure.
However, given the scale of these moves we believe fixed income investors go into 2023 on a much better starting point and we see compelling value across many parts of the asset class. For the first time in many years, we believe investors are being well paid to take both credit and interest rate risk. This current window of opportunity is perhaps best illustrated by the fact that corporate bond yields are today all in positive territory – the era of negatively yielding corporate debt is finally at an end.
We think there is especially attractive value to be found in credit, where we believe corporate fundamentals remain robust and expect defaults to remain low. Over the past couple of years, many businesses took the opportunity to refinance their debt over long periods and therefore face limited refinancing requirements over the next few couple of years. While further volatility is likely in the short term, from a long-term perspective we think credit provides compelling risk/return dynamics.
Inflationary pressures starting to ease
We expect inflation to remain a key issue for investors in 2023, although we are starting to see evidence that pressures are easing, especially in the US where headline inflation is now well off its recent peaks.
We think inflation will continue to slow in 2023, partly due to base effects and lower commodity prices, but also because financial conditions have tightened quite meaningfully over the past year. Monetary policy typically works with a 12-18 month lag, so we think the full impact of higher interest rates will only really start to be felt this year.
That said, we expect services inflation to remain elevated for some time, with the tight US labour market excepted to put continued pressure on wages. Therefore, while the Fed should be able to slow their pace of hiking as headline inflation cools, they will probably want to keep policy in restrictive territory for a little while longer, and it is seems too soon to be talking about an outright Fed pivot at this stage.
Looking beyond 2023, we think the Fed may have a more difficult job keeping inflation below 2% than they have previously. This is because many of the forces that kept inflation so low for so many years could start to unwind. In particular, globalisation is likely to be a less powerful force going forward, reflected by issues such as the onshoring of supply chains and increased use of tariffs and other restrictive trade measures.
Time to look at credit again
At this stage of the economic cycle, we think corporate bonds look well placed, offering an attractive real yield combined with resilience and diversification qualities to help withstand a more challenging market backdrop.
While the global economic outlook remains subdued, we believe that corporate bond markets are pricing in an awful lot of the bad news. Credit spreads are reflecting an implied default rate well in excess, not only of average default rates, but also of the worst default rate experience. We think this reflects an excessively gloomy outlook for default rates, and we believe investors are being well paid to take credit risk.
One of the most attractive features of corporate bonds is that they provide exposure to both the risk-free rate (government bond yields) and a risk premium (the spread between the yield of government bonds and corporate bonds). These two elements typically – though not always – move in opposite directions to each other, providing good diversification qualities during volatile market conditions.
Furthermore, in contrast to the post-pandemic period in 2020 – when credit spreads spiked, while government bond yields collapsed – investment grade bonds today provide a balanced mixture of credit and interest rate exposure, which we believe should provide a good deal of resilience as we move into a period of slowing global growth.
Another notable trend is the significant spread dispersion we are seeing across corporate bond markets – this is where bonds with the same credit rating trade at a different credit spread over government bond markets. We think spread dispersion could increase further as we move towards a Fed pivot, and this could provide a rich source of opportunities for active managers who are able to identify mispriced securities through in-depth credit analysis.
Are emerging markets the next frontier in fixed income?
2022 proved to be another difficult year for emerging market (EM) bonds, with the asset class facing headwinds on numerous fronts – from surging inflation and aggressive central bank tightening, to escalating geopolitical tensions and slowing global growth. While acknowledging the risks still facing EM assets, we think the macro backdrop should prove more supportive going forward.
The global economy is expected to grow at a pace that is neither too hot nor too cold, while the central bank hiking cycle appears to be in its final stages. This is especially the case in many EM countries where central banks were generally ahead of the curve, with some starting to hike as early as 2021.
Perhaps most importantly, inflation has started to moderate, and this trend is expected to continue in 2023. The recent fall in food and energy prices will be a key driver here, especially in many EM countries where food makes up a large component of the inflation basket. Base effects and tighter monetary conditions (which typically works with a lag of 12-18 months) should also help to drive inflation lower, providing a welcome tailwind to EM bond markets.
We also think EM bonds look compelling from a valuation perspective, with the asset class offering an elevated real yield which compares favourably with other segments of the fixed income market. While further volatility is to be expected in the near-term, it is worth noting that EM bonds have historically delivered high subsequent returns when yields have been around current levels.
While defaults are expected to rise quite sharply in parts of the EM bond market, we believe these are likely to be concentrated in specific areas, such as Chinese property, Russia and other distressed areas.
It is therefore important to be selective, although for investors who do their homework, we believe that significant value can be found in the asset class.
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