We believe that 2023 will be a game of two-halves. In light of valuations, which we believe are rich given our macroeconomic views, the first half will be about remaining defensive─ higher quality, recession resilient industries, selective on issuers. The second half is equally important. This is when we may be able to consider adding risk. This would depend on the severity of any recession, its impact on corporate credit fundamentals, the status of inflation control and, perhaps most importantly, valuations or compensation for risk taking. Markets do not operate on any particular script, but at a minimum we expect markets to offer plenty of relative value opportunities in 2023.
Rate Hikes and Tighter Financial Conditions Drive Negative Returns in 2022
The bond market went through a significant resetting of interest rates in 2022. We came into the year with short-term interest rates near zero and credit spreads near historic lows on the back of the rally initiated by unprecedented fiscal and monetary stimulus in response to the pandemic. The US Federal Reserve began a gradual shift to tighter monetary policy in March 2022 as inflation began to accelerate on the heels of strong economic growth and still impaired supply chains. This gradualism soon gave way to aggressive tightening as continued shortages, resilient economic growth and higher energy prices due to the war in Ukraine led to a surge in inflation. As a result, total returns were negative across most asset classes in 2022, especially bonds with long durations (Figure 1).
Figure 1: Fixed Income Credit Total Returns
The poor performance of fixed income assets was driven largely by changes in interest rates. This is evident in the chart above, which shows that investment grade assets, US, EU and EM, which are more sensitive to changes in interest rates than below investment grade assets, generally underperformed. Indeed, US investment grade corporate credit delivered its worst calendar year return in history, with a total return of -14.9% (Figure 2) and its worst 12-month return ever of -19.6% for the 12-month period ending October 31, 2022, underperforming even the S&P 500 (-14.6%) over this period.
Figure 2: US Investment Grade Corporates │ Calendar Year Returns: 1973―2022
On the opposite end of the spectrum, leveraged loans, which are below investment grade and carry floating-rate coupons, therefore benefiting from rising short-term interest rates, outperformed all other credit assets. Emerging market high yield debt appears an outlier relative to US and EU high yield, and even EM investment grade given its shorter duration relative to the US. Emerging markets were disproportionally impacted by the war in Ukraine, and to a lesser degree by the China property sector. For example, excluding Russia and Belarus (which were eventually removed from the bond indices completely) and Ukraine from the universe would have resulted in year-to-date returns of -11.0% for EM IG and -10.6% for EM HY.
Amid the ashes of 2022, we see opportunity and reason for optimism about the future. Below we highlight a few reasons why investors may find some of the best opportunities in fixed income that we have seen for many years.
Looking into 2023: Initially Cautious, But Fixed Income Becoming Fashionable Again
There is good reason for caution in fixed income markets in the near term. Recession remains our base case scenario in most corners of the globe given higher policy rates and inflation still above central bank targets. Add to this geopolitical uncertainties and risks surrounding China’s loosening of Covid-19 restrictions, it is easy to justify conservative positioning. To summarize our macroeconomic views:
If history is any guide, the elevated levels of inflation we see today are likely to persist for longer than many believe, even with a recession in our forecast. However, even with recession as our base case scenario, we think there are reasons to be optimistic. As a result of the historic losses experienced in 2022, yields are now the highest in years (Figure 3). Importantly, with inflation likely to have peaked in most countries around the world, further significant increases in interest rates are expected to be limited, particularly with slowing economic growth. In addition, today’s higher yields provide a some margin of safety against further increases in interest rates not present when interest rates were near historic lows a year ago.
Figure 3: Bond Yields Near 10-Year Highs Across Credit Markets │ Yield-To-Worst Range (Jan 2011 - Dec 2022)
Today’s high yields might seem unusual, but they surely are not by historical standards. The near zero interest rates of the past several years were the real anomaly. Starting yield-to-worst has also proven to be a reliable indicator of total returns over the next five years. Accordingly, the prospects for strong returns from credit markets over the next several years is the best it has been in a long time, particular if inflation has indeed peaked. However, given current economic and financial conditions, and geopolitical uncertainties, we believe the near-term still merits caution.
Fundamentals Are Solid But Vulnerable─We Still Favor Defense
On most relevant measures, issuer fundamentals remain strong today. The virtual shutdown of the economy due to the pandemic triggered a wave of credit downgrades, defaults and distressed exchanges. Many companies used the very receptive capital markets to restructure debt, extend maturities and get their balance sheets in order. Measures of fundamental strength—leverage ratios (Figure 4), free-cash-flow-to-debt and EBITDA margins—are exceptionally strong by historical measures, and interest coverage ratios are among the highest in a decade after an extended period of low interest rates allowed companies to issue debt at much lower yields than in the past.
However, slower economic growth in 2023 should pressure top-line revenues and elevated inflation is likely to shrink corporate profit margins. Corporate revenue and EBITDA growth peaked at the end of 2021 and have been declining since. In such an environment, we favor business models with strong pricing power that provides protection to their margins.
Fundamental strength varies across different segments of the corporate bond market, so sector and security selection are critical. We favor utilities, health insurance, telecommunication and REITS as these sectors have characteristics of stable margins, disciplined leverage and recurring cash flows.
Across the credit spectrum, real and nominal yields have reached decade highs that we believe compensate investors for inflation, particularly as it begins to moderate. However, interest rate risk is only one of the big risks we face as investors in corporate bonds and loans. The other is credit risk, and here the picture is more mixed.
Figure 4: Strong Leverage Ratios By Historical Measures
Valuations Inconsistent with Economic Risks
Our base case scenario is for recession in the world’s major economies, likely by mid-2023, with emerging markets likely faring better than developed markets, although it is hard to imagine they would escape unscathed. Many economic indicators are already moving in this direction. For example, global manufacturing PMIs (Purchasing Managers’ Index) dipped below the 50 level in September and services PMIs did the same in October. Central banks around the world have tightened financial conditions, credit growth is slowing and most developed market yield curves are either flat or inverted. Despite these typically reliable signs, credit spreads are generally at or near historical averages (Figure 5), with the exception of the lowest rated debt. The only exception appears to be European investment grade, which is struggling with war, costly energy, record inflation and slowing growth. Markets appear keenly aware and credit spreads have begun to reflect a highly probable recession.
Figure 5: Credit Spread Near Historical Averages
The US economy, for example, continues to enjoy robust growth and low unemployment, and despite signs of slowing, markets appear to discount the FOMC’s resolve to keep financial conditions tight for extend period and the potential ripple effects of such action. Perhaps they believe current strong fundamentals and lack of refinancing needs are sufficient to keep the default rate low in an economic downturn. Interest rate markets continue to price lower rates in the second half of 2023, so despite numerous mentions to the contrary, the markets believe the Federal Reserve will capitulate in the face of a recession.
Emerging market corporates are similarly priced with what appears to be little concern, and this may be more justified than their developed markets counterparts. The departure of challenged issuers from the investable universe, largely from Russia and the China property sector, has improved the quality of the sector and this is reflected in spreads appearing richer today than they might otherwise. In addition, EM central banks were proactive in addressing inflation, in contrast to their developed market counterparts and companies display strong fundamentals.
Nevertheless, with an economic downturn as our central scenario not reflected in valuations, we believe there is ample room for spreads to widen from current levels (Figure 6). Below are current spreads and the average levels from previous recessions.
Figure 6: Credit Markets Not Priced For Recession│ Oas In Bps
Should a recession materialize, credit spreads clearly have room to widen. Today’s high yield levels will offer some protection against spread widening, cushioning the downside on a total return basis. This is in marked contrast to 2022, where as we saw in Figure 1, higher interest rates drove the negative total returns we experienced. It is important to bear in mind that European and Emerging Markets are significantly higher quality than US markets, particularly in high yield. However, this needs to be balanced against the inferior liquidity of both markets relative to the US. During times of elevated volatility, poor liquidity can lead to more violent moves in credit spreads, even for higher quality assets. This is, in part, why issue selection in credit markets is always so critical.
We believe that 2023 will be a game of two-halves. In light of valuations, which we believe are rich given our macroeconomic views, the first half will be about remaining defensive - higher quality, recession resilient industries, selective on issuers. As 2022 delivered higher interest rates and negative total returns, we expect the first-half of 2023 to be more about wider credit spreads and a challenging environment for excess returns. If markets propagate as expected, cheaper entry points for riskier names will be available to us later in the year. Emerging markets appear better positioned than developed markets, and their bonds offer attractive yield premiums relative to equivalent developed markets companies, however, selectivity is critical, particularly in light of inferior liquidity.
The second half is equally important. This is when we may be able to consider adding risk. This would depend on the severity of any recession, its impact on corporate credit fundamentals, the status of inflation control and, perhaps most importantly, valuations or compensation for risk taking. Markets do not operate on any particular script, but at a minimum, we expect markets to offer plenty of relative value opportunities in 2023.