April 2023
After recent periods of extreme volatility in bond markets, one might ask, “Where do we go from here?” There’s never an easy answer to this question but today, it feels important to acknowledge the recent persistence of macro market uncertainty and what this means for investors. Shamik Dhar, chief economist at BNY Mellon Investment Management, shares his views on why fixed income could be more attractive now than it’s been in decades.
“If one acknowledges that elevated uncertainty means in 6-12 months’ time we could be in very different states of the world with relatively similar likelihood,” he says. “Then a sensible multi-asset approach is to be balanced, well-diversified, and defensive in portfolio allocation while maintaining the ability to be nimble as the economy evolves. Portfolio resiliency, the ability to withstand and thrive under different market environments, will be key,” he adds.
Dhar continues, “Focusing on the relative risk/reward trade-offs between asset classes, we prefer fixed income assets over equities in the near-term. Fortunately, the fixed income opportunity set is arguably more attractive than any seen in decades. And while compensation for taking duration risk remains low (many yield curves are inverted), we argue that attempting to precisely time the next big yield curve move should be avoided. Markets can move quickly and unexpectedly, as highlighted by banking sector drama in March,” he says. “Being prepared means beginning to extend duration sooner rather than later. Failing to prepare is preparation for failure,” Dhar continues.
“Staying defensive and nimble translates more specifically into a preference for cash-like and sovereign bonds that currently offer attractive yields. Our latest forecasts make us somewhat more cautious on credit exposure due to the possibility spreads can widen considerably during a recession. Remaining up in quality and pairing with active bond selection will be needed to successfully manage credit risk. As such, we continue to prefer investment grade to high yield,” he adds.
Dhar concludes: “In this environment we expect risk assets to be under pressure. However, we remain relatively positive on fixed income assets.”
BNY Mellon Investment Management’s Global Economics and Investment Analysis (GEIA) team views across fixed income asset classes:
Developed market sovereign debt: At the start of 2023, the team was cautious. The team believed there was a meaningful near-term risk of both increases in market rates, above what was priced in, and a delay in rate cuts (broadly expected to start by mid-2023). The latter was due to hawkish central bank communication and resilient economic activity. “In our view the risk of a global recession has since risen further and the sudden flare-up of US and European financial stability risks shows how quickly things can turn for the worse.” The price return components in developed market sovereigns are likely to remain volatile but the GEIA team expects they will make a positive contribution to total returns over the next 12 months. The relatively attractive levels of nominal yields provide a welcomed source of income returns, it adds.
“US sovereign bonds (Treasuries) remain more attractive than bonds in other regions. Yields on long duration Treasuries tend to fall and price returns rise after the peak in policy rates is reached. We think this is quite likely to happen soon.”
Source: Macrobond, BNY Mellon Investment Management. BIS (The Bank for International Settlements), NBER (National Bureau of Economic Research), US Department of Treasury. Data as of April 3, 2023. Past performance is not a guide to future performance.
“In Europe, core inflation and wages have not yet taken a turn lower, creating greater risks of a resumption in European Central Bank (ECB) hawkishness and a further move up in euro area yields if the economy proves more resilient than we expect. Japanese sovereign bonds are also unattractive, with no income returns to benefit from and likely negative price returns if monetary policy is normalised as we expect.”
Emerging Markets (EM): The GEIA team believes the sector will benefit somewhat from the re-opening led growth pick-up in China and a less strong trend in the USD than in 2022. However, weakening US and European demand and pockets of US dollar (USD) strength will likely weigh on relative performance – which keeps the team from being overly positive. That said, the team does like EM local currency (EMLC) debt.
“Many investment-grade rated EM economies have already seen inflation peak at lower levels than at most reserve-currency-issuing developed markets. Higher real rates, accompanied by well-established FX and macro flexibility, alongside a demand-pull from China, should allow EM local rates to withstand renewed macro downturn at the core of the global economy (or an unexpected run-up in the value of the USD).”
The GEIA team believes elevated yields in both EM USD debt and EMDLC provide a healthy cushion for price return volatility, creating a relatively positive picture for emerging market debt from a total return basis.
Global investment grade credit (IG): The shift higher in absolute levels of yields provides an income buffer but not total protection against a sell-off in the event of a recession, according to the GEIA team. Ongoing tightening of policy and financial conditions, especially in the aftermath of the credit crunch at regional banks, is likely to weigh on corporate profit margins and cash flows.
“We think that in a hard landing scenario, deteriorating credit conditions will widen IG spreads to around 250 bps from current levels (as of March 2023) of around 120 bps. Corporate yields at around 5.5% provide a partial offset against spread widening. We prefer exposure to IG corporates over high yield or EM dollar-denominated debt as historical returns in this sub-investment class have historically been steadier through recessions.”
Global high yield bonds (HY): Higher absolute level of yields provides less comfort, on a risk-adjusted basis, in comparison with IG issuers, says the GEIA team. Companies in this space feature relatively greater leverage, lack pricing power, run on thinner margins and cash buffers and face a higher wall of maturities - all of which could be problematic amid a downturn in sentiment and poor market liquidity, it says. “A prolonged period of higher yields and spreads will impede market access on favourable terms and push up delinquency rates much more than in the IG or even EM dollar-denominated credit sectors. These risks keep us on the sidelines for both US and European HY bonds.”
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Bonds are subject to interest rate, credit, liquidity, call and market risks, to varying degrees. Generally, all other factors being equal, bond prices are inversely related to interest-rate changes and rate increases can cause price declines. High yield bonds are subject to increased credit risk and are considered speculative in terms of the issuer’s perceived ability to continue making interest payments on a timely basis and to repay principal upon maturity. Investing in foreign denominated and/or domiciled securities involves special risks, including changes in currency exchange rates, political, economic, and social instability, limited company information, differing auditing and legal standards, and less market liquidity. These risks generally are greater with emerging market countries. Bond ratings reflect the rating entity’s evaluation of the issuer’s ability to pay interest and repay principal on the bond on a timely basis. Bonds rated BBB/Baa or higher are considered investment grade, while bonds rated BB/Ba or lower are considered speculative as to the timely payment of interest and principal. Credit ratings reflect only those assigned by Nationally Recognized Statistical Rating Organizations (NRSRO) that have rated fund holdings. Split-rated bonds, if any, are reported in the higher rating category. Recent market risks include pandemic risks related to COVID-19. The effects of COVID-19 have contributed to increased volatility in global markets and will likely affect certain countries, companies, industries and market sectors more dramatically than others.
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GU-408 – 5 October 2023