This article was published in August 2023.

The atmosphere in fixed income markets remains one of elevated uncertainty, as investors grapple with twin risks. On the one hand, headline inflation is coming down across developed markets (albeit at different speeds), but in general wage growth remains high and labour markets are tight – will this result in upward pressure on inflation again towards the end of the year? On the other hand, the rapid tightening that we’ve seen from developed market central banks is probably only now feeding through into the real economy – could this trigger a recession, perhaps a severe one, which would be a powerful deflationary force?

Focus on what we do know
Fortunately, amid this uncertainty, bond investors can take comfort in something we can know: yields are currently high relative to history (see chart below) across both investment grade and high yield credit. This represents an attractive carry trade, with investors being ‘paid to wait’ for the macro situation to develop, while simultaneously offering upside potential if the rate cycle does decisively roll over.

What is more, bond investors have some built-in downside mitigation in the case of recession. In a recessionary environment, spreads typically widen – however it is likely that some of this widening will be delivered through falling government bond yields, thereby reducing the negative impact on total returns. Put another way, yields are so elevated, that they provide a substantial cushion to a move wider in yields, whether in response to recessionary fears or inflationary ones.

It is also important to remember that yields are attractive even at the short end of the curve, meaning that investors can source income with only a moderate level of duration risk, consequently containing sensitivity to interest rates. Adding shorter-dated bonds at attractive yields can therefore act as ballast for a diversified fixed income portfolio.
Yields are at extremely elevated levels
The inherently asymmetric risk profile in bonds is something that all market participants must keep in mind, however, and indeed can work strongly in the favour of active investors as detailed due diligence should help avoid defaults.
Credit selection key to returns
What we’ve seen already in the first half of this year is greater dispersion in credit spreads, with the market punishing bad news and unbalanced capital structures, particularly in the lowest quality CCC-rated end of the spectrum, and an increased risk of accidents leading to a default such as the case of the US regional banks. This is where the work of experts in credit selection can really pay off, getting under the hood of issuers to understand where their vulnerabilities may lie and whether or not investors are being appropriately compensated for the risks they’re taking.

Right now my preference is to avoid companies where cash flow is coming under pressure, and particularly those that may see interest costs increase substantially either because they hold significant floating rate debt on their balance sheets or because they have significant near term debt maturities that will likely be refinanced at much higher interest rates. While acknowledging that the ‘recession vs. inflation’ debate is still unresolved, my own preference is for resilient companies that are less cyclically exposed. As highlighted above, in the current environment of very elevated yields, investors can earn such attractive levels of income whilst retaining moderate risk positioning in terms of credit selection and duration, that there is no need to own more challenged credits.

The various arguments about the likely path of growth and interest rates could be debated for hours – but I believe the macro data does not provide enough evidence to make a definitive call either way. For example, while global manufacturing data has been very weak, it is still difficult to unpick the profound effects of the pandemic which saw significant pressures on both the supply and demand side. Furthermore, the tightening of lending standards that was evident in the latest US Senior Loan Officer Survey and ECB Bank Lending Survey is consistent with increased recessionary risk, but labour markets in the US, Europe and the UK remain exceptionally tight. This labour shortage grants workers significant bargaining powers, driving elevated levels of wage growth that may ultimately reignite inflation. To illustrate this point, in the US wage growth already exceeds headline inflation meaning that workers are experiencing real-terms pay increases. The recent upside surprise in US GDP has led to increased speculation that a soft landing may be possible in the US. In my view, any soft landing would in any case not be a position of stable equilibrium – in other words, the ‘softness’ might be short-lived, turning into either a stickier inflation scenario or a recessionary one depending on the development of labour market conditions.

In general the environment is uncertain, but with yields high and various tools at investors’ disposal to manage downside risk through both duration exposure and credit selection, this is an environment where actively-managed strategies can shine.
The value of active minds – independent thinking
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