Where are the opportunities in fixed income?

For this month’s ‘A Spotlight On’ webinar, we were joined by:

-?????? Harry Richards, CFA , Jupiter Asset Management

-?????? Natalia Krol , Barings

-?????? Stephen Snowden , Artemis Fund Managers

Our panel of experts explored their views on how inflation, interest rates, and central bank action has impacted the fixed income funds they run, the UK fixed income market relative to other parts of the world and their opinion on China's growth vs other countries. Finally, they explored where and what the best opportunities currently are.

Inflation and Central Banks

In developed markets, central banks have been following an aggressive rate-hiking cycle. While some markets may pause rate increases, and some may even see cuts, inflation is proving stickier in places as it takes time for rate hikes to impact economies.

Ultimately, it may lead to a credit crunch in the United States, impacting employment. There are concerns about consumer spending in the country and an overall reduction in consumption and consumers have been seen to be downgrading and trading down to cheaper products. The bottom 50% of the US economy may be tapped out, leading to challenges for corporations and potential layoffs.?

In the UK, inflation has been slightly higher than the rest of the world for some time. Brexit and the return of EU residents to their home countries has impacted the UK employment market, which in turn affects its ability to tame inflation. However, while many indicators suggest an impending recession, the economy is still performing better than expected. That being said, the property sector is slowing, increasing concerns of a recession.

Elsewhere, emerging markets started hiking rates much earlier and were, therefore, able to ‘get ahead’ with regards to inflation in a post-Covid era. Unusually, emerging markets’ inflation is now currently comparable to developed markets, which is not typical.

Overall, while inflation has been a concern for many regions and sectors, the current backdrop indicates that gradually adding duration to portfolios for an overweight position could be beneficial. The high interest rates increases the chances of a ‘hard landing’ for many economies, necessitating a cautious approach. Focusing on better-quality sovereign debt and corporate credit is key. Picking ratings of double-B and above and favouring stability and low leverage in companies with minimal funding risks could also be beneficial.

China

The country’s reopening has been a disappointment, especially due to the slowdown in property and wider real estate sector. The Government’s policy response has been underwhelming, and there are concerns about local government funding and high leverage. China's growth outlook has slowed, impacting commodity prices and the global economy - particularly emerging markets.

Corporate Fundamentals

In terms of credit, investment-grade corporates have been proactive in managing their debt, so there isn't a wider systemic problem. However, there may be isolated cases of struggling companies due to increased funding costs. For fixed income funds, it’s important to consider the increased cost of capital and how it affects individual companies rather than the sector as a whole.

Emerging Market Corporates

The fundamentals of many of these companies are resilient, with a large proportion being in good shape. For the majority, leverage is manageable, especially when comparing emerging market investment-grade companies to their US counterparts. The high-yield space in emerging markets also has lower leverage. There are some areas of concern, though, such as China's property sector and high-yield bonds in certain Asian markets and smaller high-yield companies in Brazil.

However, while the corporate space looks resilient, market sentiment towards risk assets remains weak as demonstrated by fund flows throughout last year and this year.

The Financial Sector

In the financial sector, despite the events earlier this year with Credit Suisse and many regional US banks, emerging market banks can still look attractive thanks to having simpler business models and being well-diversified and well-capitalised. The banking sector has improved significantly since the financial crisis, with regulators actively monitoring the banks and being very much on the ball. While there are still some issues, such as commercial real estate, the core of the banking system is strong.

In other developed markets, banks are also well-diversified, but when sentiment for specific names changes (as was the case with Credit Suisse), a loss of confidence can materially test a bank’s resilience. However, in the UK, all banks recently passed the Bank of England’s stringent stress tests. In the US, smaller banks do have areas of weakness. So, with tightening credit conditions, investing in the US financial system necessitates careful analysis of fundamentals to find pockets of opportunities.

AT1s do remain investable, but the question has to be asked whether they are suitable for each specific fund.

Fixed Income Market Sentiment

All panellists agreed that there are opportunities in the fixed income market, especially as credit spreads widen. Overall, market sentiment is cautious, with investors focussing on quality assets, with lower risks and/or shorter maturities. Due to the increasing risk of volatility, there is a continued and heightened need for careful credit analysis. As a result, our experts emphasised the importance of structuring portfolios to be prepared for potential market fluctuations.

Watch the full recording here.