Fixed Income Outlook: Investing in Bonds in a Fractured World
By Vivek Bommi, CFA and John Taylor
Vivek Bommi: We started the year very concerned about growth, inflation and the impact on central banks. But recently we had the added dimension of the Russian-Ukrainian conflict which threw uncertainty into this. Can you unpack all this for us and tell us what it means for fixed income investors?
John Taylor: Recent events have only added further inflationary momentum to an already high inflationary environment. And it really caused quite a big shift in almost all central banks to become a lot more hawkish about the outlook.
GB: Now you have seen different central bank actions. Can you explain that to us?
JT: So I think the biggest divergence is really between emerging markets and developed markets. [As far as] emerging markets, central banks simply did not have the luxury of waiting to see if inflation was transient or not. They don’t have the credibility to do it.
Thus, they had to react much sooner – as many of these central banks had completed or were about to complete their rate hike cycle even before the Fed or the ECB (European Central Bank) have started. . But, now, with this additional inflationary impulse, it is likely that they may have to do a little more than they expected.
GB: Even within the developed markets space, you’re also starting to see divergences, aren’t you?
JT: So in the US that’s probably where inflation has been the highest, but there are other parts of the world where inflation is still relatively low – be it Australia or Asia. And so the big contrast is probably between Europe and the United States. At first glance, they seem to have some similarities – higher headline inflation.
But when you look a little deeper, the underlying measures of core inflation are somewhat different. Europe is somewhat high compared to the past, but well below what we see in the United States. And wage inflation, which is quite high in the United States, is practically non-existent in Europe. And that should give us and central banks more confidence that over the medium term inflation is falling relatively quickly back to target in Europe – whereas in the US it will take a lot longer efforts on the part of the Fed to obtain this result.
GB: So while they’re moving in a similar direction, it’s at different speeds, isn’t it?
GB: Now, what do you think, ultimately, what is the ECB doing, given all the uncertainty with Russia and Ukraine?
JT: So I think it was clear for a few months that the ECB wanted to take advantage of this opportunity to get out of negative interest rates. We entered negative interest rates in 2014 and it was seen as a short-term measure. Eight years later, we are still there.
So, with other central banks around the world – like the Fed and the Bank of England – making bigger rate hikes over the next year, this really was an opportunity for the ECB to exit negative interest rates. At that time, if they were to add stimulus at some point in the future, it was much more likely to come in the form of quantitative easing (QE), rather than cutting rates again in negative territory.
GB: And, if they go back down this path of quantitative easing, what kind of parts of the market will benefit?
JT: Well, I think quantitative easing has been very supportive of peripheral Europe and anything that has a sovereign spread – but also, in terms of credit markets as well.
So, I’m going to ask this question too. Given the current outlook, are there areas of the credit markets we don’t want to deal with? And, on the other hand, what areas do we think should be attractive at this point?
GB: You know, I think some parts of the market that are really dependent on strong growth are probably more sensitive. So when you think [about it]parts of the emerging markets complex [are] a bit more aligned with growth.
But where we actually see good value right now is in developed market high yield, because we had a default cycle almost two years ago with COVID. The companies that remain are in the best shape they have ever been.
And, specifically also, the companies that left, they’re not really heavy manufacturing companies that actually depend on a lot of energy as an input. You know, big sectors include healthcare, telecommunications, cable, consumer non-discretionary. These are just companies that, although the energy is impacting them, are not at a significant level to cause any credit deterioration.
And so, while we’ve seen credit spreads increase in this environment, we don’t think that’s actually leading to any of the increase in defaults that we’re seeing right now.
JT: So unlike a year ago, when all the central banks in the world had cut interest rates to zero or negative and were doing QE. Fast forward today and they were kind of pulling that QE out, as well as raising interest rates. [Those] the widening of credit spreads [are] really driven by that more than deteriorating fundamentals. Additionally, you have also seen a rise in government bond yields. So really, from an investor’s perspective, this high yield credit opportunity should really be viewed as a buying opportunity.
GB: The level of double Bs [is] the highest it has ever been. The triple C level is, frankly, the lowest it’s ever been. And again, we always see more upgrades than downgrades in the market right now. So we think right now – given where the spreads are being priced, given the actual yields you’re seeing – that’s a pretty good entry point.
The opinions expressed herein do not constitute research, investment advice or trading recommendations and do not necessarily represent the opinions of all of AB’s portfolio management teams. Views are subject to change over time.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.