Vanguard has outlined attractive opportunities for fixed income in the year ahead, even if accessing them “requires traversing a few bumps in the economy along the way”.
In its latest outlook, the investment manager stated that yield levels across credit sectors began the year at lower levels than their mid-October peaks but are still well above their 10-year averages.
It identified a strong case for credit to outperform government bonds this year, primarily due to the higher coupons on offer, and remained positive on investment-grade corporates although it was cautious on high-yield exposure.
Last year, the number of corporate credit ratings upgrades exceeded downgrades by a ratio of four to one, Vanguard said, with companies in cyclical industries that typically carry more leverage leading the way.
“As higher rates have increased the cost of capital, many companies have pivoted towards reducing debt to protect their balance sheets and credit ratings. Corporate fundamentals continue to look strong even as interest expenses rise and operating margins narrow,” it explained.
And although the upgrades weren’t anticipated to continue, Vanguard said last year’s ratings change demonstrated how investment-grade companies are adjusting relatively well. It maintained that investment-grade corporates are “entering a recessionary environment in a strong position”.
In terms of positioning, Vanguard pointed to the defensive characteristics of higher-quality credit at this point in the market cycle, with opportunities present in the banking sector that lagged the broader market in 2023.
“Bank earnings in the quarters following the US regional banking crisis that started in March last year have shown their balance sheets are sound. The recent decline in government bond yields has helped improve banks’ asset portfolios, and earnings should improve if the yield curve steepens this year, as we expect,” it stated.
It also identified an attractive opportunity in emerging market (EM) credit, given index-level yields near 8 per cent.
“The longer duration characteristics of EM credit could provide additional upside to returns in 2024 if rates move lower as we expect. We favour positions in local market rates that benefit from rate cuts in countries with restrictive policy levels and improving inflation,” Vanguard said.
“With the Fed on pause for now, EM policymakers should have more room to lower their policy rates. Patience and flexibility will be important in the quarters ahead. More dispersion across the market should unlock more opportunities for country and credit selection.”
Moving closer to home, Vanguard said it has positioned underweight Australia and Japan, stating that “markets are underpricing potential hawkish signals by central banks” in the two countries.
The Australian economy has proven more resilient than expected, it observed, with housing data and migration surprising to the upside for the fourth quarter of 2023.
“Trimmed mean inflation (the RBA’s preferred measure) was 4.1 per cent, however we don’t expect it to move below 3 per cent until at least 2025,” it stated.
“That may lead the Reserve Bank of Australia to conclude that an extra rate hike is warranted to help speed-up the fall in inflation towards target levels.”
However, Australia has not fallen out of favour with all fund managers, with Schroders recently flagging that the country remains its most favoured long duration position, and it has positioned overweight investment grade bonds, particularly in Australia, in 2024.
“With the strong rally in US investment grade credit to end 2023, we prefer the Australian and European investment grade markets which offer much more appealing valuations and the potential to outperform over the near term,” explained Kellie Wood, deputy head of fixed income at the fund manager.
“Our preference is to be owning Australian higher yielding assets like Australian bank sub-debt over global high yield that has also performed strongly and where valuations are now stretched.”
The fund manager indicated a preference for maintaining mid-curve exposure in Australia, particularly in high-quality spread products. This stands in contrast to their strategy in the UK, Europe, and the US, where they favour shorter tenors due to the higher yields on short-dated instruments compared to longer maturities.
