Last year was one of high drama that impacted most of the financial arena but bond markets were particularly damaged. It started as inflation soared, fuelled by pandemic-related labour and supply shortages plus huge injections of cash into the global economy, with rising living costs further exacerbated by war in Ukraine and spiralling energy prices.
We had been expecting to see interest rates rise as the economic cycle rotated and so they did. But the extent of the reversal, with rising bond yields compounded by the remorseless widening of credit spreads (the yield premium attached to investment-grade corporate bonds over ultra-safe government gilts), took many by surprise.
As we know, worst was yet to come. Political and economic turmoil from summer to autumn dragged on every asset class but fixed interest was hit especially hard. Then-chancellor Kwasi Kwarteng’s un-costed ‘growth’ mini-Budget sent bond spreads spiralling.
Rare buying opportunity
However, with the Bank of England (BoE) intervention and yet another change of prime minister and chancellor, what emerged from the tumult was a rare buying opportunity. Bond investors, including us, leapt to take full advantage of those huge, panic-stricken credit spreads narrowing in the final months of 2022.
Going into 2023, there is reason to remain optimistic about fixed income. Recession in the UK and Europe appears to have been narrowly sidestepped so far, suggesting that economies have been less crippled by surging energy prices than had been feared and also that the balance sheets of good-quality companies (and even some lower-quality ones) are in robust shape despite lacklustre sentiment. That’s good news for anyone holding corporate debt.
For us as bond investors, it’s the credit spread story emerging out of these various macro factors that continues to fire our enthusiasm. According to Bloomberg data, as the chart below shows, average spreads on investment grade bonds peaked at around 2.6% after the autumn mini-Budget debacle and have since fallen back to around 1.6% – but the long-term average is below 1.5%. As a consequence, we are still seeing plenty of interesting buying opportunities.
However, we remain firmly focused on the high-quality, shorter duration end of the fixed interest spectrum that has enabled us to deliver strong performance for notably lower volatility compared with sector peers over the past 15 years and through 2022 in particular.
We see little point in paying for longer duration bonds because there is almost no compensation paid for the additional potential volatility attached. To put that into perspective, the one-year gilt pays 3.87% while the 20-year gilt also pays 3.87%.
Investment-grade opportunities still look very attractive in both primary and secondary markets. For example, we recently purchased a 10-year ING bond with a five-year call (the upper end of our duration scale) yielding 6.25%. Within the Church House Investment Grade Fund (CHIG), the corporate fixed interest element now yields 5.6%, compared with 1.8% last year.
There’s an added bonus in the current environment, in that fixed interest capital values have fallen. It was only possible to buy bonds in the secondary market well above par for several years prior to last year’s implosion, but we can now buy them significantly under par.
Interest rate moves
Inflation, of course, is critical to the outlook for 2023. The indications are that consumer price inflation peaked at 11.1% in October. The latest figure for January has it falling for the third consecutive month to 10.1%. Whilst still over five times its self-imposed 2% target, the Bank of England expects the rate to fall to 4% by the end of the year.
How sure can it be? Energy prices are much lower, but wages and food prices continue to rise and geopolitical risks are not abating. BoE governor Andrew Bailey has said that the risk of a rebound in inflation is at the highest level in the MPC’s 25-year history.
UK base rate stands at 4%, its highest level since 2008. The consensus is that it will peak at 4.5%, but we do not expect a return to lower levels any time soon, given the possibility that inflation may flare up again later in the year.
Therefore, there remains good reason to steer well clear of the lower-quality end of the market - not least because these issuers are likely to find it so much more expensive to refinance in a high interest rate environment.
By using selective, active management of shorter-duration investment-grade debt to minimise volatility, we’re finding we can reward investors not only with an attractive yield but also with some capital uplift.
Opportunities, even in shorter dates, are the best we’ve seen for a decade and more: it really is an exciting time to be a bond manager.
Jerry Wharton is fund manager of the Church House Investment Grade (CHIG) Fixed Interest fund. The views expressed above should not be taken as investment advice.