Fixed income funds remained popular at the start of 2023, attracting inflows of £1.6bn in January , despite painful loses in 2022. While some remain cautious that bonds can provide positive returns, we believe underweighting fixed income right now is folly.
Our models show that we are at the point where inflation has started trending lower as households get squeezed, and the US Federal Reserve could find itself in a position where it has overtightened. Quantitative tightening affects financial instability: this policy acts with a lag and the outlook to us does not look as rosy as current data suggests.
Interest rates are markedly higher than they have been at any point since 2007 and this has generated concern in financial markets, but it is important to recognise that interest rates have historically been higher than the level maintained over the last 15 years. Interest rates were manageable in prior periods, and will be manageable going forwards.
In the meantime, volatility creates opportunity, and we will be looking to take advantage of this. We are already seeing encouraging market signals of spread widening as the UST curve has once again repriced.
However, there are still two key indicators that could affect this view: the Fed’s dual mandates of inflation and employment.
Employment data remains robust and inflation is off its peak, but still lofty. The Fed has managed the easy part of reducing inflation from the 9.1% highs to ~6.4%, but the tough job of bringing entrenched inflation down to the central bank’s 2% long term target will be extremely challenging. Hence the Fed is signalling higher rates for longer.
Moreover, China’s reopening could underpin inflationary pressures amid increasing demand for commodities and pent-up domestic demand, signalling possible higher terminal rates in the US, at the expense of growth.
The era of negative yields has almost come to an end, and today’s yields look very compelling.
At this stage of the macro-economic cycle, we are broadly defensively placed in short-end US Treasuries and undervalued bonds, and continually look for signals to rotate our US Treasury holdings and small cash positions into credit.
We have reached a point where credit spreads have begun to tighten, having widened sufficiently. Those who captured the uptick following the Global Financial Crisis and during the Dubai crisis, when spreads had blown out, were rewarded in moving from defensive AAA/AA rated portfolios towards A/BBB weighted average ratings.
Although we can invest in sub-investment grade bonds through our Next Generation strategies, we have broadly favoured high-grade, quasi-sovereign bonds issued by ‘Wealthy Nations’ as we are not constrained by indices. This means we are not exposed to the most indebted nations.
Central banks, which had injected trillions into the financial system since the global financial crisis and during the pandemic, have foregone their assumed role as buyers of last resort against financial market volatility. The end of the so-called ‘Fed put’ has been underscored by swift rate rises and the withdrawal of liquidity. For the bond market this has prompted aggressive repricing; credit is therefore now offering a wider risk premium.
We take a value-led approach, seeking to identify “mispriced” bonds within the investable universe. Once the bond has been put under the microscope during our credit research process, we decide whether or not the expected risk-adjusted return and credit notch cushion is sufficient for the bond to be included within our various strategies and segregated mandates.
The bond market has great potential to offer excess returns, especially as many investors remain underweight, which we believe will be costly to investors. There are strong opportunities for fixed income gains on a valuation and yield basis. The risk is that once everything has lined up the market will have already exploded into life.
Fred Coldham is manager of the EPIC Next Generation Bond fund. The views expressed above should not be taken as investment advice.