Aggressive monetary policy tightening, enduring supply chain disruptions, mounting recession concerns and the Russia-Ukraine conflict proved to be a toxic cocktail for risk sentiment as both stocks and bonds slumped deeper into the red year-to-date (as of 30 June 2022).
For one, the MSCI All Country World Total Return Index — the global equities benchmark — neared bear market territory, slumping more than 19 per cent in the first six months of the year. This was its weakest performance over the same six-month period since the benchmark’s inception in 1987. Bonds were similarly hard hit by the steep increase in interest rate expectations, with the Bloomberg Global Aggregate Index — the global bond benchmark — clocking its worst 6-months of performance since the inception of the index in 1989, at -13.91 per cent.
Opportunities emerge in times of turbulence
Yet, looking at the glass half full, fixed income assets are finally living up to its name. Bonds have begun to pay attractive income with starting yields significantly higher than they were at the beginning of the year across a broad range of fixed income asset classes The sell-off in the first half of the year has also increased the share of bonds yielding more than 3 per cent based on the Bloomberg Multiverse benchmark, a close to six-fold expansion from just a year prior.
Of course, a prevailing concern is if bond yields may back up higher with central banks already eyeing more aggressive action on the back of stubborn inflation and an increase in inflation expectations. As it stands, the market has already priced in an aggressive rate hike cycle, with a cumulative 13 25-basis point (bp) interest rate hikes expected by January next year. If correct, this will bring the Federal Funds rate to 3.375 per cent, in line with the end-2022 projection of the median Federal Open Market Committee member. However, this is far from certain and might be a moving target as macro conditions evolve.
Given that the Fed funds rate is only at a range of between 1.25 to 1.50 per cent at the time of writing, we could reasonably argue that markets have already priced in significant policy tightening. Financial market conditions have tightened meaningfully while volatility remains elevated amid a hasty exit from significant monetary accommodation. In addition, US Treasury yields across the curve have more than doubled since last year. It follows, therefore, that the bar for more hawkish surprises is admittedly elevated. Moderating inflationary pressures in the second half of the year and further economic slowdown could mitigate the risk of hawkish surprises, potentially offering some price reprieve for duration heavy sectors.
Higher yields with less volatility
Fixed income has also started to look more competitive to us relative to their equity counterparts. Just a year ago investors would state, almost with an odd mixture of confidence and resignation, that there was no other alternative to equities. But that argument does not hold water following the rapid rates-driven sell-off in the bond markets. The gap between the earnings yield of the S&P 500 and the yield on the 10-Year US Treasury benchmark as well as the yield-to-worst of the Bloomberg US Aggregate Bond Index have narrowed considerably despite the decline in share prices. This suggests that bond yields have increased significantly faster than the equity earnings yield. While equity market valuations have contracted meaningfully with the rise in real interest rates, higher risk-free US Treasury bond yields imply that stocks may not be all that cheap on a relative basis. Finally, there’s competition.
Indeed, after two years of remarkable stock market gains and record low bond yields, fixed income has become a more competitive and compelling play for both yield and returns. In fact, the yield on the 10-Year US Treasury and the Bloomberg US Aggregate Bond Index are more than double the dividend yield on the S&P 500 (Exhibit 8). Coupled with lower historical volatility relative to equities, bonds have again become an interesting “alternative” for investors looking to earn steady income with lower volatility.
Judicious duration exposure warranted as central banks sing from the same hawkish script
Still, the fixed income market is not a monolith. The bond market is much larger in size and scope in comparison to the stock market, with different fixed income asset classes possessing their own unique characteristics and risks, including sensitivity to interest rates. Credit-oriented sectors and in particular, non-investment grade sectors such as high yield corporate bonds and floating-rate bank loans, have low duration and are historically negatively correlated to US Treasuries. Their performances largely hinge on the overall economic outlook and corporate earnings environment as opposed to interest rates. On the flipside, higher-quality sectors and longer duration bonds tend to be the most vulnerable to interest rate volatility with rising interest rates exerting relatively greater impact on price and valuations.
With central banks on a tightening path, short duration high yield bonds and bank loans are compelling candidates to mitigate interest rate risks in portfolios. Historically, these asset classes have outperformed other fixed income segments in periods when the yield on the 10-Year US Treasury jumped by more than 100 bps.
Interestingly, a residual impact of the pandemic has also been the improvement in the average credit quality of the high yield sector. The grave economic strains of COVID-19 had flushed weaker issuers out of the credit market whilst higher-quality credits, aptly referred to as “fallen angels,” were drawn into the high yield universe after losing their investment grade sheen. Accordingly, higher-rated BB debt, we believe has grown to be more than 50 per cent of the US high yield market this year, up significantly from 36 per cent in 2007 based on Bloomberg and Barclays data.
Meanwhile, lower default rates in both the leveraged loans and US high yield sectors have also been a supportive tailwind. JP Morgan forecasts default rates in both markets to be 1.25 per cent apiece in 2022, significantly lower than the long-term average of around 3 per cent. Still, investors should be vigilant of rising credit risks as growth moderates and monetary policy becomes increasingly restrictive. Judicious credit selection will matter greatly for long-term performance.
Scouring emerging markets for yield
Beyond US shores, emerging markets (EM) continue to offer interesting opportunities for yield. For one, central banks in this side of the world had begun raising interest rates in earnest, well ahead of developed market central banks, to contain inflation and stave off depreciation pressures on their currencies. As a result, 10-year sovereign bond yields in countries such as Peru, Mexico, Brazil, Indonesia, Malaysia and Colombia have moved sharply higher, meaningfully exceeding the yield on developed market bonds, although this might also be a reflection of higher credit risks. The wide real yield differential between emerging market and developed market rates — the widest in more than a decade — as well as a voracious demand for income globally, may continue to stoke investor interest in higher yielding emerging market debt.
Meanwhile, as developed market central banks continue on their tightening path, the People’s Bank of China is largely expected to provide more monetary accommodation to buoy aggregate demand in an economy where inflation is less of a concern. A supportive macro landscape in China may be good news for other emerging markets, whose fortunes are typically tied to the growth of the dragon economy.
However, the region is not without risks. With food accounting for about 30 to 40 per cent of the consumer price basket in emerging markets, food insecurity looms large in the region on account of soaring prices for key ingredients amid disrupted supply chains, surging demand and the ongoing Russia-Ukraine crisis. Start-and-stop interventions by governments in export markets to stockpile food supplies have also exacerbated shortages. If history is any guide, persistently rising food prices typically portends political unrest in certain countries within the region which only increases the political risk associated with EM debt. Of course, the impact of soaring food prices on EM is not uniform and is largely determined by idiosyncratic factors and a mix of government policies that vary by country. This underscores the importance of selectivity and active management to navigate the risks in such a diverse region.
Even as short duration bonds, high yield credits and EM debt enjoy their time in the sun, there is still room for high-quality investment grade bonds or duration plays within a well-diversified portfolio. These assets can help mitigate downside risks and act as a strong defence during market drawdowns. This is especially important as growth concerns mount amid an accelerated and aggressive policy tightening regime and elevated market volatility.
Due to their weak or negative correlation with risk assets such as stocks, high yield bonds, private equity and hedge funds, high-quality investment grade fixed income tend to be useful as portfolio diversifiers. It helps reduce total volatility and increases the Sharpe ratio of a portfolio, thus allowing investors to be more assertive in pursuing high conviction, potentially risky alpha-generating ideas without being overly hampered by concerns about concentration risks.
In addition, we believe high-quality bonds are among a select few asset classes that can effectively mitigate drawdown risk while still providing income/return potential and liquidity with relatively low volatility. As such, bonds with deep and liquid markets are still useful as potential ballast in portfolios during periods of market stress. These safe-haven positions should remain somewhat well-anchored in the face of moderating growth and aggressive central bank policy, in our view.
The importance of being active
Market volatility and idiosyncratic risks are par for the course in the broad search for yield. Prudent credit selection often requires investment expertise with a nuanced understanding of the business, economic and political environment across different geographies. A structured and rigorous bottom-up credit selection process can help identify high-quality securities with durable fundamentals that trade below their intrinsic value as well as uncover other mispriced opportunities. These are the types of investment opportunities that may provide significant upside with a deep margin of safety.
Bottom-up credit selection aside, being nimble and having the flexibility to dynamically adjust allocations, portfolio duration and credit quality as market conditions rapidly evolve can help mitigate downside risks. This is particularly important as we face a tenuous macro environment ahead, one in which policymakers walk a tightrope of bluntly suppressing inflation whilst trying to avoid policy errors that may inadvertently push the economy into yet another recession. All this while dealing with unprecedented economic imbalances wrought by COVID-19 and geopolitical challenges exacerbated by the ongoing Russia-Ukraine crisis.
Indeed, amid elevated volatility, an active approach to investing may not just be useful, but necessary.
Brian L. Kloss, portfolio manager, Brandywine Global, part of Franklin Templeton Group