by Dewi John.
Last year was a particularly bloody one for fixed income.
It followed a miserable period for bond investors, with many who were constrained to invest in the asset class getting negative real yields (after inflation), thus guaranteeing losses. Some investment strategists had gone so far as to throw in the fixed income towel, looking instead for example to real estate for yield.
Then things got much worse for fixed income investors, as rising rates destroyed valuations. “Safe haven” sectors were heavy losers over 2022, such as the IA Sterling Corporate Bond Sector (-16.1%) and UK Gilts (-23.8%).
One of the worst performing fund classification, however, was one that you might have thought would weather the storm: Index-Linked Gilts—or Linkers—something that, given the name, should be a good hedge when inflation is running in double digits. This is because linker performance is affected by two rates: inflation and the Bank of England bank rate. If the latter rises, then the price of the linker, like any other bond, will fall. The larger the duration, the greater that effect.
Current base rates are 3.5%, up from their low of 0.1%. In November 2022, the OBR predicted that the Bank Rate would rise to 4.8% in the third quarter of 2023 and 4.5% a year later. But as rate-watchers will know, OBR predictions and reality are not always the same thing.
This has a particularly egregious effect on UK linkers, as they have a much longer average duration than, for example, the much bigger US inflation-linked market, or TIPs: the UK linker sector has an effective duration of 17.9, while its Global Inflation Linked Bond counterpart has an average of 7.5 and is down by much less over last year.
This year, however, sees asset managers bullish on bonds. JPMorgan’s 2023 outlook says the company is “more excited about bonds than we have been in over a decade”, while Charles Schwab reckons “2023 looks to be the year that bonds will be back in fashion with investors”.
Yields have rebounded over the year. What’s more, bonds are an asset class with a tendency to mean revert, and there’s a big negative gap to revert. For instance, looking at the aggregate returns on Lipper’s classification for UK corporate bonds since the global financial crisis, the strongest return was in 2009, where these funds delivered 14.9%, following the previous year’s loss of 10%.
Chart 1: Bond UK Corporate Fund Returns, 2008-2022
Source: Refinitiv Lipper
It is, of course, dangerous to read too much into a relatively short-time series, and there are many other things in the mix. One difference between 2009 and now is that the inflationary environment is very different, with the world then just about to embark on a decade and a half of artificially low rates, reinforced by the fresh-out-of-the-box policy of quantitative easing.
Rates may have further to run in 2023, and any further rates will have a negative impact on bonds’ performance until the rate cycle peaks. The Fed has signalled further rises, while the market seems more sanguine. I can claim no great insight here, but perhaps “don’t buck the Fed” may still be reasonable advice.
That said, the worst of the pain is likely behind us, governments and companies are issuing bonds with higher coupons, and the bloated principals of the previous decade have deflated, offering better value and higher yields.
That’s the case for the defence, if you will. There’s one particular niggle, however: zombies. These are companies with interest-coverage ratios below one over a defined period. For years, we’ve been hearing of the proliferation of such entities: companies only kept going through cheap money. But 2023 may be the year that the zombie chickens come home to roost, as borrowing costs return to something approaching historic norms and major economies flirt with recession.
Some estimates put zombies at roughly a fifth of the US’s 3,000 largest publicly traded companies, carrying about $900bn of debt. On the other hand, the Fed (remember those guys I just recommended not to buck?) reckons: “Zombie firms are not a prominent feature of the US economy. Among both private and publicly listed firms, zombie firms are few in number and generally small; they are mostly concentrated in the manufacturing and retail sectors and account for a small share of total credit to nonfinancial firms.”
Rising default rates are nevertheless a concern, and consensus would seem to be that this is not the time to be going overweight on high yield.
Certainly, as noted by FTSE Russell analysts regarding the collateralised loan market, financing conditions are expected to remain tight and volatile in much of 2023, with some sectors vulnerable to increased default risk because of the difficulty in passing on the rising cost to customers. Market stress and recession may therefore push speculative-grade corporate default rates to more than double next year. That would likely apply to high-yield bond as well as debt markets.
That’s likely less of an issue for investment grade funds, but we are seeing them reverse the trend over recent years of moving down the credit spectrum in search of yield. For example, Bond GBP Corporates’ exposure to BBB-rated credit—the lowest investment grade rating—went from an average of 42.3% in 2018 to 49.9% in 2021, before falling slightly to 48.3% last year. USD and EUR corporate funds have made a similar transition, from about 49% BBB to 55%, then to 48.7% and 52.2% respectively last year. However, BBB remains my far the largest credit allocation across all three regions (chart 2).
Chart 2: GBP. USD and EUR Corporate Bond Fund Credit Exposure, 2022
Source: Refinitiv Lipper
The case for fixed income has certainly strengthened, with yields offering an interesting return for the first time in years. What’s more, equities will likely struggle in recessionary conditions, making bonds relatively more attractive. But if rates have further to rise, then bonds will have more to lose. And with defaults increasing, shunning riskier credits seems wise.
This article first appeared in the Spring issue of Personal Finance Professional.
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The views expressed are the views of the author and not necessarily those of Refinitiv. This material is provided as market commentary and for educational purposes only and does not constitute investment research or advice. Refinitiv cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. Please consult with a qualified professional for financial advice.