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Investing in fixed income
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After challenging years in 2022 and 2023, falling interest rates could make bonds more attractive than cash.
In investment grade, there has been a good amount of favourably-priced new issuance across sectors.
We are more cautious on high yield, but believe some sectors could deliver positive returns thanks to momentum from a higher starting yield in the market.
2024 looks set to offer investors a good entry point to the asset class.
Both 2022 and 2023 were dominated by high inflation and interest rate hikes, which led to a sharp repricing of more duration sensitive parts of the market – government bonds and investment grade corporates. While high yield corporate bond markets performed much better, we are now more cautious of the impact of elevated refinancing costs and a deteriorating economic backdrop on more highly leveraged corporate issuers.
At the same time, investors have once again been able to find attractive cash savings rates. Why do we believe bond markets, and in particular better quality corporate issuers offer an attractive opportunity? What is there to tempt investors out of cash?
The final months of 2023 saw a strong rally in the bond market off the back of rising optimism for swift and significant rate cuts. But 2024 started with central banks pushing back against market expectations. Markets have given back some of their gains. Yields for investment grade bond markets are attractive versus the levels we’ve seen for the past decade.
Source Macrobond, ICE BofA indices, to 31/1/24.
The new issue market has given us many opportunities across a range of different types of bonds. These include investment grade, corporate hybrids and subordinated financials. One area where we have been extremely selective is high yield.
In investment grade, although credit spreads are tight, reflecting healthy fundamentals, attractive yields and relatively low net new issuance is already driving flows into the asset class. We’ve also seen a good amount of new issuance that we believe to be well priced, across the board.
Examples we’ve added to our more investment grade focused funds include:
In high yield, there has been very limited new issuance over the past couple of years after corporates issued extensively in 2020 and 2021. As a result, the ‘maturity wall’ is getting ever closer and corporates will have to fund at much higher rates than they’ve previously been able to.
This, coupled with deteriorating economic data, including rising insolvencies and delinquencies, is making us more cautious on high yield.
In those funds with a bias towards higher yielding parts of the market we’ve been improving the overall credit quality. This reflects our view of the challenges that many high yield borrowers will face in an environment of higher borrowing costs, but also serves to protect against the risk of an economic slowdown.
Whilst it’s uncertain whether an economic slowdown will happen, we have far more certainty around the risks that higher borrowing costs pose to the high yield bond market. We’re very wary of those borrowers with higher leverage, whose balance sheets were put together in a very different borrowing environment. Even factoring in further declines in interest rates and yields, these companies may not be able to refinance at an affordable level.
It’s notable that there’s been a clear dispersion between the yield demanded for stronger and weaker credits. While the spread on European BB and B-rated bonds fell, those on bonds rated CCC and below rose substantially.
Source Macrobond, ICE BofA indices, to 31/1/24.
This scenario, while challenging, should offer good alpha generating opportunities and will ultimately reward active portfolio management and a rigorous credit selection process. Although aggregate spread levels are not generous, we do still expect European high yield to deliver positive total returns in 2024 thanks to carry from the higher starting yield in the market.
While we’ve reduced exposure to high yield companies, we’ve been happy to take some more exposure to subordinated debt in stronger companies. We’ve increased investment in corporate hybrid bonds. These are junior bonds but the issuing companies are typically large, investment grade-rated names.
We’ve also added to subordinated financials, including AT1 bank debt. Following the sell-off last March, both banks and regulators have taken steps to ensure the continuing health of the AT1 market and it has performed well.
Source Macrobond, ICE BofA indices, to 31/1/24.
Example of recent issues include:
In funds with a focus on delivering a high income, we can take a little more credit risk at the issuer level, and find examples such as:
To answer our earlier question, of what’s out there to tempt investors out of cash - interest rate cuts are expected from the US Federal Reserve, European Central Bank and Bank of England in the first half of this year. Falling interest rates will feed through quickly to the rates achievable on savings accounts.
In bond markets though, we continue to have the opportunity to ‘lock in’ attractive income streams that can benefit the funds for many years, without taking on too much in the way of credit risk. We have already started to see early signs that investors are reallocating from cash to bond markets, especially investment grade.
Yields remain attractive and may maintain positive relative value
Significant focus on the uncertainty of the US macroeconomic backdrop and its potential implications on the market remain top of mind for investment opportunities. Against this cautious outlook, we asked the experts from Invesco’s bank loan, direct lending and distressed credit teams to share their views as the third quarter of 2024 wraps up.
Monthly fixed income update
Fixed income markets in July saw yields rally in response to weaker economic data which brought forward expectations of rate cuts. Read our latest thoughts on how fixed income markets performed during the month and what we think you should be looking out for in the near term.
Global Fixed Income Strategy Monthly Report
In our regularly updated macroeconomic analysis we offer an outlook for interest rates and currencies – and look at which fixed income assets are favoured across a range of market environments.
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
Views and opinions are based on current market conditions and are subject to change.
This is marketing material and not financial advice. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication.
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