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Webinar highlights: Flexing your fixed income allocation in evolving markets

Webinar highlights: Flexing your fixed income allocation in evolving markets
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    Fixed income webinar

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    On 25 May, we ran a one-hour fixed income webinar. The aim of the session was to help clients steer their portfolios in a clearer direction. We discussed several macroeconomic scenarios, their market implications and what this might mean for asset allocation.

Executive digest

  • A challenging 2022 for fixed income has created meaningful opportunities in bond markets.
  • The most likely path ahead is one of global deceleration, according to our Global Market Strategy team, with inflation “coming down reasonably quickly”.
  • This environment could be supportive of investment grade credit – but also select opportunities in high yield.
  • The potential weakening of the US dollar could bring emerging market debt into play.
  • Floating rate senior loans are currently one of the highest yielding assets in fixed income.
  •  Volatility in markets rewards investors who are flexible and “do their homework”.

Read on for an introduction from Tony Wong, and for the full roundup from each session.

Foreword

tony wong

 

 

“How many black swans make a flock?” It might sound like the start of a bad joke or a piece of trivia. But, in fact, this is a question that an Invesco colleague asked on a recent call. The tone was tongue-in-cheek, but the underlying point was a serious one. The macroeconomic environment we have lived through over the last three years has been volatile. Focusing on 2022 alone, the words “annus horribilis” spring to mind, as both bonds and equities suffered dramatic losses against a backdrop of war, inflation and rate hikes.

We are now a few months into 2023, and it is shaping up to be more promising. The bond market selloff in 2022 created good valuation opportunities and, for the first time since the Global Financial Crisis, there are meaningful income opportunities to be found in bond markets. Of course, it hasn’t all been plain sailing, as recent turmoil in the banking sector has highlighted. But, for investors who know where to look, there are opportunities to be found.

Against this backdrop, Invesco hosted a fixed income webinar on Thursday 25 May. The aim of the session was to help investors navigate macroeconomic uncertainty and steer their portfolios in a clearer direction. In this roundup, we provide a summary of the key topics covered on the day. I hope you find it useful.

Session 1 roundup: “The macroeconomic backdrop”

Introducing the panellists
panellist iamge

Paul and Kristina began the webinar with a conversation about the global economy. Paul introduced his macroeconomic base case, before delving into two alternative scenarios. The most likely path ahead is one of global deceleration, in his view, with inflation “coming down reasonably quickly”. In this scenario, Paul is expecting the Federal Reserve to start reducing rates in the second half of the year, which “probably means that the dollar will weaken”, he added. 

In terms of asset performance, this is a combination of good news and bad news. On the one hand, it means weakening economies. But, on the other, it also means interest rates starting to come down. Overall, “we favour defensive assets”, Paul outlined, “so fixed income over equities”. In terms of asset allocation, he sees fixed income “playing an increasing role compared to what we have seen over the last five or six years”. In other words, “bonds are back”.

Within the asset class, high yield and investment grade credit come out as favoured areas under Paul’s base case. However, with the dollar likely to weaken, it’s also an “exciting time” for assets like emerging market debt, added Kristina.

Session 2 roundup: “Is risk being rewarded?”

Introducing the panellists
panellist iamge

After the introduction from Paul and Kristina, we moved into our first panel discussion. Giuliano D’Acunti, our host for the session, opened the conversation by highlighting the importance of two key things: a global perspective, and a flexible approach. These themes ran throughout the discussion, as the speakers reflected on a macroeconomic environment where both risk and opportunity are abundant. 

“Inflation is sticky and the data on economic activity paints a conflicted picture”, said Stuart Edwards. However, “after years of unconventional central bank policies, quantitative easing and zero rates, investors are finally getting paid for taking risk”, he added. The yields on Euro investment grade are in excess of 4% and, for Sterling, they are closer to 5.5%.

For Alex Ivanova, this volatile backdrop is creating a rich environment for active investors. “We have observed quite a big dispersion between better quality names and weaker, lower-rated triple-C bonds”, she added. “If you do your homework and you feel comfortable with the fundamentals, you can get very attractive yields.” 

A point of agreement was the need for flexibility, and the ability to react quickly to events as the economy transitions from a period of inflation to one of deceleration and potential recession.

This session concluded with a look at emerging market debt – a key area of opportunity identified by Paul and Kristina at the outset of the webinar. Hemant Baijal spent some time reflecting on Latin America, where yields have been compelling. However, he also warned that investors should not be too quick to disregard other markets where yields are not so high, citing India as one example. “The reason yields are lower in these markets is typically because inflation has not been as high – so the opportunity set is still attractive”, he said.

Session 3 roundup: “Where are inflation and rates heading?”

Introducing the panellists
panellist iamge

The final session of our webinar focused on the direction of inflation and monetary policy, before delving into the asset class implications. Kate Dwyer, who hosted the session, kicked things off by reflecting on the recent turmoil in the banking sector. A common question at the moment is whether investors should be focusing on higher quality assets. 

Responding to this, Paul Syms focused on the direction of travel in government bond yields. By the end of 2022, these had risen by almost 4% from post-pandemic lows. “Investors are no longer being penalised for investing in higher quality asset classes like government bonds and investment grade credit,” he said. 

Lyndon Man built on this argument, focusing in on investment grade. If the next stage of the economic cycle is one of economic contraction, with heightened recession risk, there could be “a desire for high-quality, duration-sensitive assets”, he said.

We concluded the session by moving on to private credit, homing in on floating rate securities like senior secured loans. If inflation continues to persist, this asset class could look particularly attractive. “I don’t think the story of inflation is fully written yet,” said Michael Craig. “We don't know how long rates are going to be at this level for”. Senior loans are currently one of the highest yielding assets in fixed income. “If you look at the sort of margin above the floating rate, that's the highest it's been for six years,” said Michael.

Answering your questions

Thank you for submitting your questions during the webinar. We didn't have time to get through them all on the day, so we are following up here. If you would like to discuss any of these topics in further detail, please do get in contact with your local Sales representative.

Paul Jackson, Global Head of Asset Allocation Research

While UK Consumer Price Index (CPI) data for April 2023 was higher than expected, it did signal a continued decline in the headline rate of inflation to 8.7% from a peak of 11.1% (in October). More worrying, of course, was the rise in core CPI inflation to 6.8%, which is a new high for this cycle and could suggest that core inflation is yet to peak.

However, this does not cause us to change our central scenario, other than reinforcing the idea that the Bank of England (BOE) will tighten more than the US Federal Reserve (Fed) over the coming months and be less likely to ease as the year comes to an end. Though inflation may be proving stickier than some had expected, it seems to us that there is a clear downward path in the US and that Europe is likely to follow with a lag (as was the case on the way up). Europe’s inflation pressures were greater than those in the US during 2022 for two obvious reasons. First, European natural gas prices were boosted by problems with supply from Russia and, second, dollar strength boosted European import prices. The UK has faced even greater problems due to the extreme weakness of sterling after Kwasi Kwarteng’s mini-budget (and, of course, the ongoing effect of Brexit on the free flow of trade).

Most of these factors are reversing (energy prices are down a lot and sterling has recovered), so we would expect UK inflation to moderate as the year progresses. Problem areas in UK inflation data include:

  • Food (processed food and non-alcoholic beverages): +21.1%year-on-year
  • Energy (electricity, gas and misc.): +25.8%
  • Transport insurance: +38.5%
  • Package holidays: +13.5%

Food prices seem to be slowing (based on monthly gains) and we would expect this to continue as wholesale price declines feed through the supply chain. Likewise, energy prices are already falling on a monthly basis. This will be passed through to households in the form of a recently announced lowering of the energy price cap.

Package holiday price gains are probably related to continued strong post-pandemic demand and earlier gains in energy prices. The energy price element has disappeared, and we would expect UK demand for holidays to moderate. Finally, the gains in motor insurance may be linked to the fact that insurers can no longer offer lower rates to new customers in order to gain market share, which has no doubt pushed up average rates upon renewal.

Overall, we think the UK has some particular features that caused inflation to be higher than in the US, for example, and for longer. However, we can see that some of these unique pressures are easing. Hence, we do not see the UK data as a reason to change the global outlook. That said, we are aware and keeping an eye on the global situation.

Stuart Edwards, Fund Manager, Henley Fixed Interest team

Duration is an interesting topic at the moment, and one we have been discussing at length as a team. For years, we were known for taking a low duration stance. However, that has changed recently across a number of our portfolios. My colleague Lewis Aubrey-Johnson recently filmed a video sharing our latest thoughts, which you can watch here. But let me summarise the main arguments. On the one hand, some investors are nervous about increasing duration risk at the moment – and this is understandable:

  • Firstly, core inflation is proving fairly sticky.
  • Furthermore, there are some big offsets to tighter policy at the moment, including lower energy prices and excess savings. And, on top of this, there is typically a significant lag between policy and impact. It takes a long time for the economy to slow.
  • Finally, the US and bund curves are already inverted, giving up carry, and the upside may be limited.

Despite this, we have decided to increase duration across some of our portfolios for three key reasons:

  • The world is witnessing the most aggressive central bank tightening in a generation, and higher yields are starting to have the desired effect. Against this backdrop, the question about lags and offsets is more a question of timing than direction of travel. As Lewis outlined in his video, if you wait until you are comfortable taking duration risk, you’re probably already too late.
  • While duration isn’t particularly cheap, the sterling credit curve is actually pretty flat, so you don’t give up much yield by extending. Furthermore, by buying longer-dated bonds, you’re locking in the income for longer.
  • Finally, if overall yields fall, the extra duration will mean you’re getting “more bang for your buck”.

Lyndon Man, Co-Head of Global Investment Grade Credit

We are positive on duration over the medium to long term. This is based on our view that we will transition away from a stagflation backdrop to a stagnation backdrop. In other words, we think we will see a disinflationary trend and lower growth as we move towards the next stage of the economic cycle and contraction/recession risks. In the short term, however, we expect bonds to trade in a range caught between tight monetary policy and disinflation. The countervailing forces of positive growth and inflation, combined with negative financial conditions, will likely keep markets unsettled until central banks turn more dovish.

Alexandra Ivanova, Fund Manager, Henley Fixed Interest team

It is certainly encouraging that attractive yields are available from so many more sources today, including high yield bonds. However, our outlook for the global economy and for high yield bond markets remains cautious.

At the broad level, we do expect some further spread widening. As a result, we have been rotating into better quality high yield bonds as well as reducing exposure. We can still find attractive yields in other areas where we see a more attractive balance of risk/reward. These include selective bank AT1s, corporate hybrids and emerging market debt. In these areas, we can find similar yields to those in high yield bonds, but often in better quality issuers.

The good news within high yield is that there is once again differentiation across issuers after a long period in which the asset class traded with little differentiation. For us, it is important to remain selective and active in the face of a more challenging economic backdrop.

In general, the fundamentals in the high yield market are robust. Leverage on a net basis is coming down and cash balances are high. We think that the default cycle is still ahead of us, but it will take time. Meanwhile, there are opportunities in high yield that are already priced through a recession. We are well positioned in our team to take advantage of them while remaining cautious in general.

Invesco doesn’t have an overall house view. Our investment teams are free to develop their own outlooks based on the specialist research they conduct, which often results in healthy discussion and diverse opinions. In addition, our range of ETFs can help investors to gain diversified, yet targeted, exposures to certain asset classes like AT1s. To help answer your question, we have collected insights from a range of different teams across Invesco.

Paul Syms, Head of Fixed Income ETFs

The Swiss authorities’ decision to write down Credit Suisse’s AT1 bonds in March created doubts around the asset class, as the decision overturned the capital structure by prioritising common equity over AT1s. However, crucially, other European authorities have stressed that this is not how they would treat AT1 bonds.

In a joint statement on 20 March, the European Central Bank, the European Banking Authority and the Single Resolution Board confirmed that, for those banks under the EU’s jurisdiction, AT1 bonds would only be written down after all common equity Tier 1 capital had been exhausted. The Bank of England also issued a similar statement.

Overall, we believe AT1 bonds are worthy of consideration by institutional investors seeking higher yields within a diversified fixed income sleeve, potentially diversifying exposure to senior debt. However, the convertible nature and subordination of AT1s does make them riskier than senior debt and the Credit Suisse experience demonstrates the need for due diligence before making an allocation to the asset class to ensure its suitability as part of a multi asset portfolio.

Views from the Henley Fixed Interest team

In our view, the initial fall in AT1 and share prices was an understandable reaction to an unexpected event, but it was not reflective of the underlying fundamentals. AT1 prices opened sharply lower following the Credit Suisse rescue but have been steadily recovering.

The initial selloff left the AT1 market largely priced to perpetuity. This suggested that banks would no longer call these bonds, but rather leave them outstanding. Since then, however, the market has recovered quite a long way and increasing numbers of bonds are now once again priced to call.

We’ve recently seen the first AT1 call by a European bank since Credit Suisse’s failure. UniCredit called its €1.25bn 6.625% AT1. This call is notable because it shows that European banks wish to demonstrate the strength of their capital positions and continued commitment to the AT1 security type post-Credit Suisse (market convention is to call AT1 bonds unless the cost of replacement capital is significantly higher). Unicredit suggested that it has no need to issue new AT1 securities in the near term because it already has a large excess of CET1 capital (the capital ratio which includes AT1 capital and the bank's equity). This call also shows ongoing regulatory support for the AT1 market, as all calls have to be approved by the regulator.

It makes sense that investors are asking for more premium to own this asset class after what happened with the Credit Suisse AT1. Structurally, however, we argue that the AT1 market was designed specifically to improve the resilience of the financial system as a whole after the Global Financial Crisis. As such, it would only make sense for regulators to continue to make sure it functions properly in the future.

We think the sector offers very attractive income with the potential for capital growth as investors begin to see banks continuing to call these bonds.

Lyndon Man, Co-Head of Global Investment Grade Credit

We believe the Credit Suisse event was an isolated case within the European banking sector. We would highlight that both EU and UK regulators have said they would respect the credit hierarchy. AT1s are, in our view, investible and offer attractive yields on banks which are strongly capitalised and fundamentally sound. We expect the risk premiums on subordinated debt to normalise and compress over time as the market refocuses on the strong credit fundamentals rather than the negative sentiment from these idiosyncratic events.

Hemant Baijal, Head of Multi-Sector Portfolio Management, Global Debt

Decarbonisation will require a significant amount of capital expenditure (capex). This expenditure will be led by governments globally from China to India and Europe.

The increased capex could be of significant amounts. Current estimates suggest that, in order to meet decarbonisation targets, the world will need a USD20 trillion capex cycle over a decade. Even if these targets are not met and it takes longer than this, the amounts are likely to be meaningful.

The impact of this cycle will likely mean higher growth globally and more resilient inflation. In such a long cycle, the excess savings globally are likely to decline. This could have a significant impact on the US dollar, which has been the biggest beneficiary of such excess savings. For emerging markets, it would indicate more balanced growth and less of a reliance on global commodity trade, in our view.

Lyndon Man, Co-Head of Global Investment Grade Credit

We see opportunities in both European and US banks, and favour the national champions in Europe and US Global Systemically Important Banks (GSIBs). On the whole, we believe they have strong balance sheets. This includes high levels of capital as a result of stronger regulation since the Global Financial Crisis.

Specifically, within Europe, we do not see a readthrough of either the SVB or Credit Suisse events. We view these as more idiosyncratic than systemic. For example, European banks have stickier retail deposits and limited exposure to tech/venture capital. They also broadly benefit from higher rates given their asset and liability mix.

Investment risks

  • The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

Important information

  • All data is provided as at 30 May 2023, sourced from Invesco unless otherwise stated.

    This is marketing material and not financial advice. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication.

    Views and opinions are based on current market conditions and are subject to change.