Whilst the exact path and speed of monetary policy easing remain uncertain, it appears clear that we have passed peak hawkishness and that central banks such as the Fed are moving back to focusing on their dual mandate of inflation and employment. This is significant, as it suggests that central banks are now looking to extend the cycle with gradual rate cuts over time, rather than end the cycle through aggressive rate hikes, which had been the fear for much of the past couple of years. In addition, this development has taken place at a time when economic growth remains resilient, especially in the US, and pushes any recession fears further down the line.
When we look at valuations, we appear to be at a unique moment within fixed-income markets as well, where you can currently find yields in the higher-income segments of the market such as high yield and AT1s, which are above the historical average annual returns for global equities. We therefore entered the year with a positive bias towards credit, with a preference towards these higher-income segments given the robust growth backdrop. Whilst rate volatility and uncertainty around the Fed’s terminal rate weighed on credit spreads at times in 2023, this should be less of a headwind in 2024. Recent data and communication from central banks also suggest to us that this rate-cutting cycle will likely be very gradual in nature. As such, investors should view their allocation to fixed income as being more strategic, given that yields and the attractive carry argument could be in place for a longer period of time.
With regards to specific segments of the market, we believe that the high-yield segment through CDS indices is compensating investors more than adequately for the risk being taken, since at such elevated yields the power of accrual becomes extremely important. Yields of just below 10% in dollars here also provide a buffer against any bouts of spread-widening as was clearly observed in 2023. Interestingly, CDS indices are today trading relatively cheap to the equivalent high-yield cash bond market, which means that investors are being rewarded today for being in the more liquid product. Furthermore, we anticipate that the benign default rate backdrop will continue in 2024 given resilient growth and with limited near-term refinancing risks as companies have already been able to begin terming out their debt.
We also view the BB-rated segment of the credit market as providing a good risk-reward relative to BBBs for example, offering a 2% higher historical annualised return whilst exhibiting a very similar volatility profile. In addition, default rates between these two rating cohorts have tended to be very low and similar, with default risk picking up significantly as you move lower in the rating spectrum. Finally, we continue to see value within the AT1 market from both a valuation and fundamental perspective, where the sector continues to recover from the volatility of March last year. Positively, we have continued to see investor-friendly announcements being made towards the asset class. These announcements initially came from regulators, but now also from issuers, who have consistently called their bonds in recent quarters, despite the market still only pricing around 60% of the AT1 universe to call, which highlights the valuation argument that still presents itself. The earnings of banks also remain impressive and highlight how this sector should remain a key allocation in a higher inflationary and rate environment.
Overall, when thinking about portfolio construction, we are in favour of a barbell approach whereby investors have an allocation to these higher income segments mentioned above, but also to short-dated floating rate notes for the more conservative part of the portfolio. For example, a high-quality, short-dated investment-grade floating rate note portfolio has a yield today that is significantly higher than a traditional investment-grade bond portfolio that holds more interest rate duration, due to the inverted yield curve. In addition, despite the central bank’s cycle of hikes having ended, we still view an allocation here as appropriate given that this cutting cycle may be much more gradual, which allows investors to continue to take advantage of the elevated yield offered by such FRNs.
Mohammed Kazmi