Rain or shine: What investors are considering for fixed income this summer

Key points:

• Uncertain macro outlook with central banks remaining fixated on inflation and recessionary risks still around
• Credit continues to offer potential opportunities, but investors may still want to keep an eye on inflation-linked bonds
• Short duration continues to look attractive however some investors may consider extending the duration

Perhaps it is that the summer sun is shining, but the situation in the US seems a little rosier than projected earlier this year: the US Federal Reserve (Fed) demonstrated its intention to “stay put” for now by pausing interest rate hikes and, currently, economic data is not overwhelmingly pointing to recession. However, despite the Fed pause, there are suggestions that future hikes are not out of the question, and the debate over whether we will see a recession or a soft landing will continue to be a focal point. 

Overall, central banks remain fixated on inflation and recessionary risks still exist, as demonstrated by the European Central Bank, Reserve Bank of Australia, and Bank of Canada all having raised rates by another 25 basis points in June.

Fixed income investors continue to see historically high yields across the bonds market. Even if the Fed’s pause means yields fall and the range that has been in place in 10-year Treasury yields (3.25% to 4% since last November) is broken to the downside, expectations are for the bond market to remain steady.  

With such clouds threatening to block the sunshine, where might investors look for opportunities within their fixed income portfolios?

Credit strength continues in 2023

So far in 2023, the US investment grade market has experienced positive yields which has helped revert the negative returns of 2022 with some positive numbers this year as income has taken over.

Annual Returns: ICE BofAML US Corporate Index YTD

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Source: AXA IM, ICE BofAML as of 31st May 2023. It is not possible to invest directly in an unmanaged index. Past performance is not a guide to future performance. There is no guarantee that the market will experience the same momentum as in the past few years.

It is also evident that company fundamentals remain solid: strong nominal earnings growth has allowed leverage to come down, and borrowers have been able to raise money in the bond market in recent months, allowing them to build up cash buffers in case growth does weaken markedly.¹

Opportunities in high yield but need to know what to look for

European high yield valuations are currently attractive, with yields near their highest levels in over 10 years; levels which have historically been associated with positive subsequent returns.

European High Yield Valuations

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Source: AXA IM, Bloomberg as of 19th June 2023

European high yield is still offering investors a yield pickup of around 350bps² over the investment grade market, which may help compensate for the additional credit risk, especially when considering that the asset class is nowadays predominantly BB-rated.

From a sector perspective, recessionary concerns mean that sectors that have been most dispersed were those most affected by default sensitivity such as media, retail, and telecom. In this environment, we continue to see potential in defensive credits in sectors such as capital goods, telecommunications, and healthcare.

In the US, the default rate has continued to be a focus for investors, given the expectation that it will increase as the economy weakens. We expect the increase to be at manageable levels and in the region of 3-4%, partly because only 30% of companies have loans, and most companies can afford higher interest rates. We, therefore, do not envisage a major deterioration in broad corporate fundamentals. As seen in May, however, with two high yield bond defaults and three distressed exchanges, actively analyzing individual names, we believe, will be important for assessing opportunities across high yield markets.  

How investors may consider inflation-linked bonds

While surveys suggest that inflation and inflation expectations may have peaked, service prices and wages remain strong, giving weight to our view that inflation, and particularly core inflation, may remain sticky for the foreseeable future. As markets have priced-out rate cuts for 2023, we find it interesting that breakeven inflation rates are almost unchanged and trading close to central banks’ targets.

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Source: AXA IM, Bloomberg as of 31 May 2023

We believe that real yields, which are close to cycle-high levels, may offer potentially attractive as inflation-linked bonds offer both duration and inflation exposure.

Emerging market debt may offer growth and opportunities for higher risk investors

For investors with a higher risk appetite, emerging market debt (EMD) may offer an alternative landscape to that being experienced in developed markets. EM sovereign balance sheets remain stronger than G7, and the overall budget deficit in EM will be almost back to pre-Covid-19 levels in 2023; a faster progress in fiscal consolidation than in G7.

EM budget deficit closer to pre-Covid 19 level than G7

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Source: AXA IM – Real Assets, IMF, JP Morgan, Macrobond; EM excl China as of October 2022, G7 as of May 2023

There are also trends that are offering opportunities for investors such as ”near- or ”friend-shoring,” favoring selected emerging markets at the periphery of the US or euro area rather than de-globalization and re-shoring to developed markets.

Flexible duration management

With the yield curve remaining inverted, short duration continues to show potentially positive signs given the value at the front end of the curve. For cautious investors, short duration may also mitigate against future interest rate increases and widening credit spreads. However, as it is likely that most of the job of monetary policy tightening is done, investors may also consider extending the duration as we get closer to the first cut in rates. The pace of rate hikes is slowing and a hard recession across the main markets is looking less likely, giving room for hope. However, the macro outlook remains uncertain with recessionary concerns, the expectation of further interest rate hikes and with inflation likely to remain sticky for the foreseeable future. Overall, this low growth environment has historically been positive for fixed income returns, particularly for risk assets such as high yield where high levels of carry on offer still exist. Even for cautious investors, this situation could offer opportunities across strategies such as short duration and investment grade credit.

Past performance is not a reliable guide to current or future performance.