Credit markets offer new opportunities in all sectors, with initial yields of between 5.5% and 8.5%.
As the interest rate cycle around the world approaches its highs, we could be at an inflection point for the bond market . Or that’s how, at least, some analysts see it, thinking about 2024. Credit markets offer new opportunities in all sectors, with initial returns of between 5.5% and 8.5% . The context is set to obtain positive long-term total returns.
“Initial yield is often a good indicator of the total return to be expected from longer-term bonds. This means that investors have to obtain positive and convincing returns on their long-term debt investments in certain areas of the fixed income markets , with the advantage of enjoying a lower volatility than that of equities,” says Flavio Carpenzano. , director of Fixed Income Investments at Capital Group.
There are no investors who have had more interest in the economic paradigm shift that has occurred in the last three years than those in fixed income. “Trends related to demographics, deglobalization and decarbonization are redefining the investment landscape,” analyzes Julien Houdain, head of global fixed income without limitations; Lisa Hornby, head of US multi-sector fixed income; and Abdallah Guezour, head of emerging market debt and commodities at Schroders.
Fiscal dynamics in the United States and other developed markets remain an issue , while inflation is here to stay and geopolitical tensions add another layer of uncertainty .
Inflation has been higher than in the previous decade and yields, both real and nominal, on higher-quality bonds are now at 15-year highs. “This makes them look cheap both in absolute terms and relative to other asset classes, especially versus equities,” comment Guezour and Hornby.
Inflation and growth are losing steam and most central banks are reaching the end of their rate raising cycles . Historically this has been a time when investing in fixed income offers the greatest reward .
Against this backdrop, the poor profitability data that has been recorded in the last three years has become history. “Furthermore, in terms of valuations, both in absolute terms and relative to other asset classes, bonds are trading as cheaply as they have been for the last decade and higher yields already offer a significant cushion to offset potential further declines.” price”, highlight Guezour and Hornby.
The new paradigm
The market has already fully assimilated the scenario of higher rates for longer in a context in which inflation has not completely subsided.
Decarbonization, deglobalization and demography will probably end up leading to other “Ds” with serious consequences for fixed income investment: debt, deficit and default .
Fiscal management is intrinsically linked to debt dynamics. The transition to a new era in which financing costs are higher is likely to perpetuate a vicious cycle that will compound accumulated debt levels in the coming years.
“A steepening of yield curves is foreseeable, which would mean an increasing difference between short- and long-term bond yields. In fact, we see value in strategies that take advantage of the steepening of the yield curve in various markets,” highlight Guezour and Hornby.
All of this indicates that bond yields will be structurally higher , but also that market divergences will become more visible as trends in different regions differ.
Outlook for major credit sectors
Currently, managers are finding opportunities across the spectrum of credit markets. When it comes to high performance, the resilience of the American consumer has surprised some experts. “We have seen how this resistance manifested itself through the persistent strength of consumer spending on travel and leisure, which favored cruise line issuers and the gaming sector,” highlights Carpenzano.
Greater spread dispersion is also creating idiosyncratic opportunities in investment grade companies . Valuations of certain global financial institutions and the largest and most well-capitalized US regional banks in the senior tranches do not necessarily reflect underlying fundamentals and are trading at wider spreads than our analysis suggests is justified.
Certain issuers in the utility sector also offer potential, benefiting from stable profitability and improvements to their distribution network to protect against natural disasters such as forest fires.
Valuations in certain segments of the ABS market (subprime auto and rental car) appear to be pricing in a moderate downturn, but more senior tranches may be able to withstand a more severe downturn in the economy.
In emerging market debt, managers are finding value in Latin America, where central banks have been more proactive than those in developed markets in raising rates to tackle inflation . “Examples include several Latin American sovereigns in the high-quality investment grade rating cohort, such as Mexico, as well as high-yield-rated issuers, such as the Dominican Republic, Colombia and Paraguay,” says Carpenzano.
