Investors should be prepared to lengthen duration and add risk when opportunities arise during the year. For higher risk appetites, AT1s and corporate hybrids are still our preferred way of achieving yield pick-up.
Key messages
- Short-term investment grade offers the best risk-reward ratio, providing an attractive yield coupled with low exposure to upward moves in rates/spreads.
- AT1 contingent convertible bonds (CoCos), hybrids and commodity players offer the desired pick-up for risk-tolerant profiles.
- A move higher in rates/spreads would offer the opportunity to rotate into more aggressive segments.
Fixed income is back
Fixed income is back in portfolio managers’ good books after a decade of yield repression comes to an abrupt end as central banks scramble to hike rates in an effort to contain inflationary pressures.
While 2023 is shaping up to be another difficult year for the economy, investors can now earn attractive returns in the comfort of developed markets’ short-term high-quality bonds – something not seen since the Global Financial Crisis (2008–09).
Keep duration low
The central banks overseeing the 10 most heavily traded currencies delivered a total of 2,700bps of rate hikes in 54 separate instances during 2022. The Fed, ECB and BoE slowed the pace of rate hikes towards the end of the year, leading government bond yields to ease.
Irrespective of the move, policymakers have made it clear that they will keep rates elevated for “longer” in an effort to fight stubbornly high inflation. This leads UBP’s Investment Committee not to expect any rate cuts this year, contrary to the consensus, which has priced in the Fed’s first rate cut in the second half of the year – which is why we highlight the use of floating-rate notes in portfolio construction.
With the backdrop of hawkish central banks, quantitative tightening and extreme economic uncertainty, coupled with a yield curve that does not reward extension risk and spreads at undemanding levels, we are taking a cautious approach, keeping portfolio duration low.
Short-dated investment grade
Due to rising rates, a short-term double-A rated bond offers a higher yield than a single-B one did just twelve months ago. This creates the opportunity to rebuild carry strategies at attractive levels in fixed income portfolios.
In our view, deploying capital at a yield of 4% in EUR and low-5% in USD and GBP with very little duration/spread risk, while waiting for the economic picture to become clearer, provides the best risk-reward for the time being.
Commodity players
We expect commodity prices to stay resilient given the tight supply dynamics and geopolitical tensions. Bonds issued by commodity players, including metals & mining companies, offer attractive yields and low duration, and are backed by strong fundamentals.
AT1 CoCos & hybrids for yield pick-up
In a time of uncertainty, AT1 CoCos of major European banks and hybrids of well-established companies continue to allow investors to earn higher yields by taking a subordinated position.
Despite the slowing economic growth, years of tough regulation have forced European banks into a very strong capital position, while the balance sheets of national champions are “battle tested” – this is why we have repeatedly made room in the portfolio for these bonds.
Risks and considerations
The global economic growth slowdown is set to take a toll on corporate profitability, which means added importance should be given to credit selection in cyclical sectors, as default rates may well rise in the coming months.
We see longer-term rates moving higher as investors take the path of least resistance given the hawkish posture of central banks. With this in mind, our positioning would naturally underperform in a scenario where longer-dated rates moved downwards (i.e. deeper recession leading to a flight to safety – not our central scenario).
At the same time, we expect the year to be volatile and provide numerous opportunities to gradually rotate from the safer investment-grade overweight into more aggressive high yield and emerging markets.
Disclaimer: This article is relevant for non-benchmarked Advisory portfolios and focuses solely on our highest conviction ideas within the asset class.
Filipe Alves da Silva