Is it time to get excited about fixed income?

Last year was terrible for fixed income. All parts of the market – from US Treasuries to emerging market (EM) corporates – delivered negative returns. The deterioration in credit markets was driven by now-familiar factors: soaring inflation, rising interest rates, the war in Ukraine, fear of recession and the blow-up in the Chinese real estate market. Outflows from bond funds were their highest in decades.

So, given all this gloom, why are we excited about 2023? First, let’s look at inflation. Few expected the pace and extent to which inflation climbed in the West in 2022 (it remained muted in much of Asia). Many central banks, led by the US Federal Reserve (Fed), responded by aggressively hiking rates. As we head into February, the medicine appears to be working. Inflation has started to recede, particularly in the US. 

But the improving outlook doesn’t mean inflation is behind us. We expect prices to fall but not hit central banks target by the end of the year. We also think some market participants are underpricing this ‘stickiness’. Under these conditions, we think inflation-linked bonds are still a good investment at this stage.  

End of the hiking cycle?

What about interest rates? As we all know, rising interest rates are bad for a fixed-rate investor. However, while we think rates have further to go, we believe we’re nearing the end of unprecedented global coordination of monetary tightening. The timing of the eventual rate cuts (or rate stabilisation) will depend on each country and the depth of potential recessions. The Fed, for example, is forecast to begin reducing rates towards the end of 2023. Europe and the UK – both of which were behind the curve – are likely to be later.  

Given this, we believe we’re currently at an attractive entry point for certain fixed income assets. Short-dated yields are back to levels not seen for a long time, with credit spreads also providing a reasonable proportion of the total yield.   

As for emerging markets (EM), several nations – Mexico, Brazil, Chile – were quicker to raise rates beginning in 2021. Some entered recessions, while the strong US dollar and high funding costs meant that a few countries, such as Sri Lanka, defaulted. But after a tough year, conditions are on the up. Inflation is falling, which should allow central banks to stabilise rates later in the year before cutting towards the end of 2023. For investors, markets have already priced a lot of pain into EM spreads. On a risk-reward basis, we therefore think EM could deliver positive – if volatile – returns. 

Are we still headed for a recession?

This relatively good news doesn’t mean we should ignore the risk of a central bank-led recession. The impact of interest rates always lags, and we expect the full effects to be felt in the coming months. Leading indicators also still point to a downturn. Inventories are high, while US unemployment is weakening. Carmakers, always quick to read the runes, are beginning to offer discounts to sell cars. 

Nonetheless, we think the downturn will be milder than previous recessions. Bank balance sheets are relatively strong. Many corporates are also in better shape than in previous economic downturns. This should result in fewer ratings downgrades and defaults than a typical recession. China, meanwhile, is reopening its economy after three years of Covid restrictions. Gas prices, a major factor for European economies, have fallen thanks to a mild winter. And, of course, central banks look set to start easing towards the end of the year.

Final thoughts…

Following a terrible 12 months, things are looking up for fixed-income investors. Inflation is receding, while the rate-hiking cycle is nearing an end. We think that any upcoming recession should also be milder than widely expected. And company balance sheets are generally in good shape, which should help them weather tougher economic conditions. Given these factors, we think many fixed-income assets currently offer a compelling entry point. 

As it stands, we favour a broad range of fixed-income assets, which are benefiting from significantly elevated yields compared to recent years. Investment grade credits (the bonds of more highly credit-rated companies) currently look more attractive than high yield credits (the bonds of less creditworthy companies). However, the latter should improve later in the year. We also generally like EM debt from a risk-reward perspective but, as ever, selectivity will be paramount.