Themes in focus for Global Strategic Bonds

Key points: 

• Having a flexible duration management approach has been key in these volatile markets
• Investment grade credit looks like the sweet spot following 2022’s repricing
• Picking the winners and losers in the high yield market

Many of the issues that have dominated the headlines for most of this year are still at large on the macro stage: central bank monetary policy, inflation and the energy crisis. However, within the fixed income market, there are now some positive signals emerging which are drawing the attention of bond investors keen on locking in a bargain.

High yield bonds are issued by companies with a relatively low credit rating, which may not have been able to access capital markets in the past. The asset class offers investors a higher risk, higher return opportunity than more traditional fixed income markets.

Here we look across the three risk buckets, Defensive, Intermediate and Aggressive¹ , that break down the fixed income universe for the Global Strategic Bonds strategy and discuss the themes that we are currently focussing on.

Defensive: Duration management

We view Defensive bonds as those where performance is predominantly driven by interest rate movements. Our flexible approach allows us to adjust our duration according to our tactical views and the point in the economic cycle. The rates environment has been volatile this year, with the global government bond market at the epicentre of the sell-off, driven by inflation which has proved to be stickier than many expected and central banks which were too slow to tighten financial conditions.

In the second half of the year, our duration management has worked much better than the first half, when we tried to add exposure on a couple of occasions, only for yields to head higher once more. We extended duration in July, capturing a bond rally driven by short-lived speculation that the Fed might slow the pace of interest rate hikes or pause entirely. We then cut our exposure in August and September following renewed focus by central banks on tackling inflation at all costs. To reflect this bearish view, the strategy began September with a duration close to zero years.

The strategy is long only with an overall duration leeway of 0-8 years, but we can implement negative duration strategies on the curve or on a cross-currency basis when we feel it’s appropriate. We came into the period of heightened UK volatility in late September with a slight negative GBP duration position. This was based on our view that UK gilts could underperform given double digit CPI prints that showed no signs of easing, and a new government with a fiscal policy agenda that seemed at odds with the Bank of England’s mantra to tighten financial conditions to fight inflation. This position helped to protect the strategy during the very negative market reaction to the UK government’s “mini-budget”. Upon the Bank of England’s intervention to support long-dated gilts, however, we added back to GBP duration, which worked well as gilts subsequently rallied back.

As the chart below shows, the ability to manage duration in a flexible way saw the strategy’s duration go from its highest to lowest exposure in a matter of weeks:

Daily duration management: 2022 YTD

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Source: AXA IM as at 11/11/2022. 

We sit today² with a more bullish duration position following the first signs in early November that headline CPI in the US might be easing. We prefer US treasuries and expect the curve to steepen after many months of flat and inverted yield curves, with short-end valuations now pricing in a lot in terms of the Fed’s terminal rate.

Intermediate: Adding investment grade opportunities

Investment grade credit has been hit on both sides in 2022 by higher government bond yields and wider credit spreads. On a forward-looking basis, however, the asset class now looks attractive in terms of risk-reward opportunities: the combination of government bond duration risk and high-quality credit risk offers investors a yield of anything between 5% and 8%. Put another way: equity-like returns with fixed income risk. This stands in stark contrast to many years in which investors have been bereft of yield – turning to lower rated credit or even more illiquid asset classes instead.

The bulk of our 30% Intermediate bucket exposure is in sterling and euro credit (21%), which now price in a lot – both in terms of yield and spread. In October, a basket of A-rated sterling credit yielded close to 7% and euro credit above 4% – higher than anything seen in the last ten years.³ BBBs look particularly attractive to us on a spread basis, given the greater underlying credit risk, with 25% of our overall credit exposure invested in BBBs. We do also hold US credit exposure (10%), although do not think spreads in the US currently fully compensate for potential recession risk, considering how resilient the US economy remains for now.

Within the investment grade space, we like banks and insurance companies, which offer a yield premium for subordinated debt or bonds which have some sort of optionality over the call date, compared with simple bullet maturities from the same entity. This is because bank and insurance bonds that are issued below senior level will have call structures and be treated differently by the market, regulator and rating agencies depending on evolving capital requirement.

Naturally as bond investors we are focused on yield and spread, but the other aspect worth bearing in mind is the potential for significant capital appreciation, given how much bond prices have fallen this year. The average price on a Global Corporate Index – composed of investment grade credit – recently fell to 85 for the first time this millennium.⁴ Although default rates are set to pick up, there are plenty of good quality single name opportunities that offer a significant “pull-to-par” benefit as they approach maturity – making short duration credit an attractive place to invest.

Aggressive: Benefitting from dispersion in high yield

Our largest allocation in what we describe as “equity-like” fixed income is US high yield, where we see great value. The broad US High Yield Index currently yields around 9%.⁵ Clearly, it’s a fixed income asset class, but with much higher default risk and most of its yield derived from credit spread, rather than rates. Hence its returns correlate more with equities than the government bond market.

That said, this is not a market in which we think “passive investing” wins. We see a real mix of opportunities in the current market given the growing dispersion, making the ability to ignore whole sectors or single names key to driving outperformance versus the market. For example, we are currently avoiding segments of the retail sector, most notably department stores, due to pressure on the consumer that should come through in the higher rates regime.

The other theme within our US high yield exposure is the ability to overweight lower rated (Bs and CCCs) smaller issue sizes compared to the broader market. Nearly a third of our US high yield allocation is in issue sizes smaller than $500m, which would not be included in some ETFs’ investable universe. We have found great relative value in these smaller issues, partially due to a high liquidity premium for bondholders and the inability of larger strategys and passive strategies to invest in these credits, resulting in a higher yield for these securities.

While market volatility continues to be a headwind, the medium-term prospects of higher yields, combined with a weakening global economy, which should be positive for fixed income, suggests to us a much greater return potential moving into 2023. In the meantime, we feel that our bias towards higher quality government bonds and credit, together with the structural diversification in place across our three risk buckets, means we are well-positioned for unpredictable markets.