Colin Finlayson, fixed income investment manager at Aegon AM, says market conditions have been a perfect storm for the bond market so far this year. But “vigilante-style” routs have led to historically attractive valuations in the market which present a clear opportunity to investors.
“Steep inflation and subsequent monetary policy tightening, combined with a weakening economy and unnerving geopolitics, have created a ‘perfect storm’ for bond markets.
“Vigilante-style routs have led to higher bond yields, while spreads are now closing in on some of the highest levels seen since the Global Financial Crisis. These broad market moves have led to historically attractive valuations across the asset class.”
Despite cautioning from central banks such as the US Federal Reserve, Finlayson says the early signs of an inflation turn are now there.
“Inflation has dominated and continues to steer market sentiment. During this year, we have, however, seen strong counter-trend rallies in the US on the perception of a Fed pivot towards a more dovish stance and hopes that inflation has peaked. Fed officials have been quick to discount this, telling the market ‘not so fast’.
“Now, though, early signs of a turn in inflation are being hinted at through various indicators. Even once we reach a peak, it is still unclear how quickly prices will return to ‘normal.’ Interest rate hikes have been an inevitable consequence of tackling the inflation problem.
“Most of these hikes now seem to be priced-in, with rates set to exceed 3% across many economies. This includes the European Central Bank and Swiss National Bank, both waving goodbye to negative deposit rates. Expectations for future interest rates are now better aligned with the outlook for inflation, although looming recession or a fall from peak inflation could question this position.”
Government Bonds outlook
Finlayson believes yields could still be pressured higher while looking for peak inflation. But he says the market has already priced in most of the rises in inflation and rates.
“Yields could still be pressured higher by rising inflation and subsequent central bank tightening in the short term, although the bulk of the heavy lifting is behind us. We favour incrementally adding duration, while looking for signs of a peak in inflation rates and yields to begin adding more meaningful interest rate risk.
“Curve positioning and relative-value cross-market positions have been important to generating alpha; we have implemented a curve-steepening position in the US and continue to identify disparities across rates markets to add relative-value positions.”
Investment Grade outlook
With investment grade bonds, cost/margin pressures will increase, but this is more of an equity story rather than a credit-specific issue, according to Finlayson. Focusing on financials and non-cyclicals at the higher end of credit quality is a way for investors to mitigate this, he says.
“Market volatility will remain the key risk to this. We have a strong overweight in investment- grade credit, with a preference for financials and less cyclical corporates, as well as companies rated at the higher end of the credit-quality spectrum.”
High Yield outlook
On high yield, Finlayson says the preference is for European credit, short dated with a higher spread. Current values are very attractive as it looks like double digit default rates are unlikely, despite the market pricing in otherwise.
“Central bank actions have led to improved and attractive valuations, both in spreads and all-in yield available across credit markets. Corporate fundamentals are still decent in high yield companies, although careful security and sector selection remains paramount to generating alpha.
“We favour the European high yield market versus the US and seek shorter-dated, higher-spread assets. In 2023 we believe we will see an increase of default rates in the high yield market from the current historic lows of 2%, to around 5%.
“The market is currently pricing in a double-digit default rate in European high yield for next year, which we don’t believe will materialise. This leaves present valuations in high yield looking very attractive.”
|
