Fixed income: peak, pivot, descend?

Peaking, pivoting and ready to descend. But how rapidly?

	Yannik Zufferey, PhD CIO, Core Business
	Philipp Burkhardt, CFA Fixed Income Strategist and Portfolio Manager

 

Need to know: In the previous issue of Alphorum, we commented that while the fog over the macro landscape was starting to lift, the path ahead was still not entirely clear. The Federal Reserve has now clearly signposted the route for rates – and it leads rapidly down This decisive change of gear – with four rate cuts flagged for 2024 – seems almost irrationally exuberant, leaving a risk the bank has overplayed its hand. Short-term curve flattening could still occur if cuts are delayed There can be no doubt that this pivot, and the peak rates it signals, supports the case for fixed income. We are diversifying across credit and duration, sticking to quality and complementing this approach by prudently moving down the credit-risk spectrum

 

New year, new paradigm

Given the events of recent years, it would be an act of bravery to claim to be able to predict the state of the world at the end of 2024. Yet, at its December meeting, the Federal Reserve (Fed) appeared to do just that. The bank released a statement signalling its intention to make no fewer than four rate cuts over the next 12 months, backing this up with dot plots and doubling down with a press conference free from pushback to ensure a dovish message.

Having spent the previous year keeping markets guessing as to when they might show their hand, Fed Chair Jerome Powell and his colleagues pushed all their chips to the centre of the table and called with confidence: their message was that not only are we at peak rates, but we will soon be on a downward trend. Like the Grand Old Duke of York, Powell has marched us up to the top of the hill and now aims to march us down again. He has not planned time for any of us to catch our breath or enjoy the view!

 

A decisive change of gear

To understand the Fed’s sudden exuberance, it is perhaps helpful to remember the central bank’s dual role: on the one hand it must aim to control inflation and ensure price stability, but on the other, it is expected to oversee a healthy labour market and strong levels of employment. At any given point in the cycle, it must try to decide the best trade-off between one priority and the other.

Given resurgent inflation in the wake of the pandemic, the Fed had little alternative other than to focus on bringing prices under control, especially as employment levels proved resilient. But with the work now seemingly done on inflation, the bank must put on its other hat and ensure that any slowdown doesn’t turn into a recession, with the negative consequences that would have for the labour market.

What made the Fed’s decisive change of tack so surprising is that as recently as 9 November, Powell was still relatively hawkish, stating at an International Monetary Fund research conference that Fed officials were “not confident” that the battle with inflation had been won. Partly in consequence, market sentiment right up until the meeting was based on rates peaking but staying higher for longer. Then, in one fell swoop the Fed effectively went from cautious and hawkish to what might almost be seen as an irrational level of exuberance.

 

Overplaying its hand?

There can be no argument that this is a pivot – and a pronounced one at that. Given its inability to anticipate the events of recent history, the Fed might have been expected to act with a little more caution. Instead, it appears to have regained full confidence in its forecasting abilities and is keen to announce the fact.

In many ways the stars seem aligned – growth is easing, and both the labour market and wages are turning. However, unlike in the European Union (EU), whose economy is inherently more fragile, inflation doesn’t seem to be taking a consistent downward path in the US but has instead more recently moved sideways. The risk is that by laying its cards on the table with such a flourish, the bank leaves itself very little room to manoeuvre. We’ve come a long way, but the real world rarely follows the smooth graphs of mathematical modelling; having nailed its colours firmly to the mast, the Fed could be caught out by anything less than an orderly descent in inflation.

Several potential deflationary factors have yet to manifest clearly in the US economy up to this point. For example, a much-expected correction in the housing market has yet to materialise, since although there is lower demand for housing, low supply is keeping prices relatively buoyant. Similarly, while the huge stock of savings accumulated during the pandemic should be depleted by now, this has yet to be reflected significantly in US consumption. The logical approach at this stage would therefore seem to have been to put rates on hold and wait for more persistent and conclusive signs of falling inflation across the board before signalling a move downwards in rates.

The Fed’s actions seem doubly surprising given that financial conditions had already eased considerably. In fact, November was the strongest month for fixed income performance since 1995. However, based on its ‘impulse indicator’, the Financial Conditions Impulse on Growth Index, the Fed believes that the peak effect of its actions in raising rates has been reached (see figure 1).

 

FIG 1. The Fed’s impulse indicator shows the effects of raising interest rates has peaked

Source: FOMC website as at 05 January 2024. 

 

Remembering the Fed’s dual role, it may be that it sees decisive action as necessary at this point to provide the US economy – and particularly the labour market – with necessary levels of support. Further, the number of US banks needing support in the wake of Silicon Valley Bank’s collapse in March 2023 may be a sign that the US economy is more fragile than it appears.

While we cannot know the central bank’s full motivations for its actions, this is certainly the closest it has come in this cycle to a ‘soft landing’ narrative. However, that is not an easy outcome to engineer. There is a potential risk the Fed has loosened its restrictive stance too early and too decisively. Should its bet be proved wrong, its credibility could potentially be tarnished, and that could cause issues down the road.

 

Big implications

While we have some concerns that the Fed may be putting all its eggs in one basket with such a decisively dovish pivot, we are happy that its actions create plenty of strong arguments to be invested in fixed income. Curves could still flatten again in the short term if the Fed’s message proves too aggressive and rate cuts have to be delayed, but once they begin to deliver, bull steepening should occur.

The key question for investors is, with cash still benefiting from relatively high rates, which assets could offer a potentially better overall return? In terms of fixed income, those who have yet to reinvest have already missed some outperformance in the rally during November and December. Rates are attractive, but spreads are at the tighter end (see chart below). However, as we explain in more detail in the government bonds section of this Alphorum, performance following the first rate cut in past cycles suggest there is still potential for sovereign fixed income to benefit further.

 

FIG 2. US Treasury yields are still at the high end of recent ranges, even after the recent rally

Source: Bloomberg, LOIM at 31 December 2023.

 

In total return terms, rates and credit shouldn’t be too dissimilar. It is worth remembering that curves are still inverted. Investment grade (IG) spreads only just compensate for this, meaning that IG to cash is effectively flat. However, simply staying in cash ignores the reinvestment risk. We believe the best approach is therefore to stick to quality fixed income, diversify across credit and duration, and complement this by prudently moving down the credit risk spectrum.

We continue to favour sovereign debt, believing that opportunities to lock in higher yields persist, making these markets more attractive than cash. Our view of credit markets remains neutral, but opportunities for credit pickers are emerging now that the varying fundamentals and refinancing demands of companies are coming in to view. 

 

Source: LOIM at 29 December 2023.

Can rallying sovereigns extend gains on cash?

Nic Hoogewijs, CFA  Senior Portfolio Manager

 

Need to know: In the wake of the Federal Reserve’s dramatic pivot, sovereign fixed-income markets have shifted rapidly from pricing in higher-for-longer rates to anticipating when and to what extent they will be cut We see uncertainty from inconclusive labour market data, political risk and the lag in transmission of policy tightening to the real economy. Some ongoing market volatility is therefore likely in the short term Tactical concerns aside, the run-up to the first rate cut should continue to benefit sovereign bonds. With cash rates set to fall sharply, investors will have opportunities to lock in yield with a longer duration

 

Fundamentals and macro

As discussed in our lead article, the Fed’s decisive pivot in December confirmed the intended end of the tightening cycle for it and most other major central banks. Economic growth data released over the final quarter of 2023 had largely surprised on the downside amid rapidly falling inflation pressures, strengthening the case that global inflation would normalise by late 2024. This led to a change in tone from the central bank officials – including some on the hawkish side of the spectrum – and paved the way for the Federal Open Markets Committee (FOMC) to shift decisively to a more dovish approach. In September, the median of Federal Fund rate predictions by FOMC participants in the so-called dot plots showed just 25 bps of cuts in 2024; the December projections were for 75 bps of cuts over the same period.

The Bank of England and the ECB conveyed a more mixed message than the Fed, but showed no urge to push back against rapidly building market expectations of significant policy rate cuts for 2024. Even the Norges Bank, which delivered a rate hike in Q4 2023, indicated it would likely be the last for this cycle. The Bank of Japan is an outlier and is set to reduce policy accommodation in 2024. However, recent communications indicate its intention to provide ample forward guidance and avoid any surprise moves.

In this context, the market has shifted rapidly from pricing in higher-for-longer rates to anticipating when and to what extent they will be cut. For our part, we await further evidence labour market conditions are easing sufficiently for core service inflation to fully normalise. Investors should also bear in mind that both academic research and the Fed’s own findings indicate policy tightening has yet to fully transmit to the real economy. It is therefore not impossible that expected inflation could creep up again before heading decisively downwards. With year-end pricing fully anticipating a rapid policy easing cycle starting as soon as May 2024, such a scenario would inevitably spur renewed market volatility.

In emerging markets, meanwhile, most central banks are well into their easing cycles, with countries including Brazil, Chile, Hungary and Poland all cutting rates.

 

Sentiment

While government bond markets recovered from the double-digit negative returns weathered in 2022, most of 2023 was still disappointing for investors. Sovereign interest rates continued to face upwards pressures from rising real yields, particularly in the long end of the curve. Surprisingly strong economic data, nervousness about ongoing deficit spending and elevated net issuance all weighed heavily on investors’ appetite for sovereign paper. As a result, year-to-date returns of the flagship sovereign indices were in modestly negative territory at the end of the third quarter.

However, from late October growing evidence that tightening financial conditions were impacting economic activity began to turn sentiment around dramatically; this sharp Q4 bounce saw the Bloomberg Global Treasury Index (EUR hedged) close the year up 4.36%¹. Commodity Futures Trading Commission data indicate that while real-money investors such as asset managers have maintained a long bias over recent quarters, speculative investors have been heavily underweight US Treasuries; we suspect this short positioning has contributed to the speed and extent of the dramatic fixed-income year-end rally.

 

Technicals

High net supply combined with quantitative tightening mean price-sensitive private investors will need to step up as official buyers retreat in 2024. Elevated volatility in fixed-income markets is partly a reflection of market participants’ search for a new equilibrium. We see some evidence that historically attractive interest rates are supportive of private sector demand. For example, in the eurozone, overnight deposits for household and corporates are down almost EUR 1 trillion from their peak in August 2022.²

Deposit outflows are set to persist in 2024 as savers seek better yields. Retail banks remain reluctant to pass on higher policy rates to savers, a fact reflected in the net interest margin for banks reported in the latest European Banking Authority dashboard. As a result, we firmly believe households will continue to look for better returns elsewhere. Several European governments have deliberately facilitated this search for a better home for savings, with Belgium, Portugal and Italy all stepping up retail funding significantly.

 

Valuation

The cheapness of sovereign bonds that we flagged in the last edition of Alphorum was largely unwound during the year-end rally. As 2023 came to a close, investors were pricing in nearly 150bps of rate cuts for the federal funds rate in 2024 – up from just 50bps anticipated at the end of October.³ The front-end repricing triggered a sharp rally across the curve, with the 10-year US Treasury yield closing the month down 0.6% at 3.9%. Other major developed bond market interest rates also repriced sharply lower, albeit most with a beta lower than one versus US Treasuries.

From a tactical standpoint, we turned somewhat more cautious on outright duration exposure into year end. Cash rates look attractive following the rally, with highly inverted curves, particularly in the very front end. But with this situation unlikely to persist, pressure on savers and investors is mounting and we expect many will be looking to buy any dips.

Analysis of the excess performance of sovereign bonds versus cash in the 12 months either side of peak rates in the 1995, 1998, 2001, 2007 and 2019 cycles shows that sovereigns tend to outperform cash, particularly in the six months leading up to the first policy rate cut (see figure 3). As can be seen, this analysis indicated that outperformance is still possible after the first rate cut but this tends to be more dependent on the cycle, as cuts tend to be priced in already. While some of this outperformance has already been delivered in this cycle, past evidence suggests that some further outperformance can still be expected in the coming quarters.

 

FIG 3. Sovereign-bond market performance before and after the first federal funds rate cut for current and past cycles

Source: LOIM, Bloomberg, FTSE at January 2024. Past performance is not a reliable guarantee of future results.

 

For emerging-market (EM) sovereign bonds, there is a debate to be had as to whether value can still be found. We were constructive on EM sovereigns in the second half of 2023 thanks to the combination of their natural yield advantage (albeit at lower levels than the historic norm) and high US Treasury yields. Assuming EM currencies do not depreciate significantly, EM government bonds will still offer some pickup, but with US Treasury yields having rallied, the overall argument for EM sovereigns is less compelling.

 

Outlook

More than 18 months into one of the fastest tightening cycles in recent history, evidence is growing that key cyclical data have turned decisively. However, we expect market conditions to remain volatile in the short term, creating a risk that the Fed has acted prematurely by signalling multiple rate cuts for 2024. In this context, the recent sovereign fixed-income rally may be somewhat overextended.

The Fed’s pivot remains highly data dependent, and the supply outlook is challenging; while we see ample room for private-sector investors to absorb new issuance, they will be highly sensitive to pricing. Meanwhile, the political landscape adds to market uncertainty: around 40 national elections are expected in 2024, not least the US presidency and the risk a re-elected Donald Trump could introduce reflationary polices, such as tariff increases.

Beyond the complications of these more tactical considerations, we see current multi-year-high cash rates falling sharply over the next 18 months. Consequently, investors will be looking for opportunities to lock in yield with a longer duration.

 

Sources.

Fundamentals are back

Ashton Parker Senior Portfolio Manager and Head of Credit Research

 

Need to know: For a decade, fundamental analysis in corporate credit has mattered little compared to previous years: price differentiation was limited, firms could borrow cheaply and central banks stood ready as buyers of last resort, making defaults rare However, with central banks starting to withdraw credit market support and higher interest rates threatening to flush out ‘zombie’ firms, sectors including consumer cyclicals and real estate are starting to look more vulnerable We see idiosyncrasies rising in the coming months, bringing fundamental analysis back to the fore. We like the higher quality end of BB-rated bonds, where bigger, better-managed companies have more financial flexibility

 

For a decade, fundamental analysis has been of limited importance in corporate credit. Price differentiation for investment-grade (IG) bonds was extremely limited, and with central banks buying up IG credit almost indiscriminately, companies could borrow at virtually zero interest rates irrespective of whether they were graded AAA or BBB. Defaults were therefore low, even while zombie companies were potentially being created.

That situation has changed. Central banks are withdrawing from their role as buyer of last resort, while higher interest rates will start to have a material impact on those companies which have failed to focus sufficiently on their fundamentals.

 

Turbulence ahead for airlines and other consumer cyclicals?

Looking ahead, we see warning signs for consumer cyclicals. While not quite back at pre-pandemic levels, global car sales rebounded strongly in 2023, while hotels and airlines benefited from the post-pandemic travel boom. However, we believe demand in these sectors may fall materially in 2024 as consumers start to react to the economic slowdown.

For car manufacturers, the momentum behind electric vehicle (EV) uptake appears to be slackening. Consumers may defer decisions until the situation becomes clearer, particularly as purchase and new leasing costs are high. This will make little difference to the underlying credit, but it may cause some price weakness if manufacturers fail to meet sales targets.

Similarly, we believe consumers may sacrifice city breaks and shorter holidays as economic conditions tighten. While sector names including Ford, Accor and Lufthansa⁴ have been upgraded back to IG in recent months, we see potential for the auto and travel sectors to underperform in 2024.

The one major outlier in all this is likely to be cruise companies. As we saw in 2008, most consumers will not forgo their main annual holiday. As an all-in package, cruises tend to be better value than hotel-based breaks, and a high percentage are sold to mature holidaymakers with steady pension income and no mortgage – who are actually benefiting from higher savings rates. Also, the pandemic has driven a shift towards prioritising experiences over big-ticket material purchases, such as a new car.

 

A real problem?

While we have concerns about real estate, it is also where the most interesting opportunities lie. With prices having fallen across the board, those able to pick the winners and avoid the losers could reap healthy rewards. Generally, real-estate companies don’t fail. Despite eroded values, they still enjoy massive asset bases. Meanwhile, mortgages are costly and higher construction costs are limiting supply and keeping demand strong. Rental demand is therefore healthy, and vacancies are generally low and quite stable. What’s more, most rents are inflation linked, and tenants will only fail to pay as a last resort. All this means that residential markets have generally stood firm.

Office space is less solid, particularly in many US cities and in London, where longer commutes and larger residences make working from home more attractive. In these locations, lower office attendance suggests companies may seek smaller premises when leases expire. But in general, the potential to lock in 15-20% returns over five years in the downward part of the ratings cycle makes property bonds highly attractive, depending on assessments of the likelihood of default – which in many cases is low. At the same time, the cash price of bonds is as little as 50-60% of face value; in the event of default, a bondholder is owed face value, so as the relative recovery value is proportionately higher, the potential loss is less than having bought the bond at par.

 

Crossover: the place to BB

While we are neutral on high yield (HY) and IG, we like the bigger, better-managed companies at the higher quality end of BB rated credit, which tend to have better banking relationships and more levers to pull to refinance. By comparison, smaller B and CCC rated companies often have less liquidity and depend on a single core product, making them more vulnerable to cyclicality.

For IG credit, the likelihood of default is essentially zero, so there is limited justification for losing out on additional return by buying an AA over a BBB grade bond. By the same argument, fallen angels stand out, since despite being downgraded to HY, they are usually large companies with previously strong fundamentals. They often have more financial levers to pull, such as access to equity or shadow-banking markets, or non-core assets to sell; that makes them better able to withstand a downturn and subsequently refinance.

Bondholders will be supportive of a company facing liquidity challenges but can refinance, even if they do this in the secured banking market – which will result in rating downgrades due to unsecured bonds. Possible default is of course cause for concern, since unsecured bonds will be subordinate to the secured debt; however, a company that has demonstrated its capability to refinance is less likely to fail.

All this means investors are getting paid for BB and potentially BBB positions. Taking a little more duration at the lower end of IG than in HY may make sense, locking in a decent return on the assumption that rates are going to fall.

 

FIG 4. Higher refinancing costs will impact debt serviceability for B and lower rated credit

Source: LOIM calculations, Bloomberg at December 2023. Forecasts use the following assumptions: current yields are representative of yields over the coming two years, so are the yields at which maturing debt will be refinanced; and the interest burden of maturing debt is equal to the average coupon rate of debt maturing in the next 24 months (cost of expiring debt). All other factors are constant. Please note that estimates do not contain any analyst-based expectations and are for illustrative purposes only.

 

Why IG beats cash

There are those that would make the argument that if IG credit is offering the same basic returns as cash, why take any risk at all? The answer lies in duration. If interest rates fall you will be paid less for cash, and may decide to move into IG. However, you will have missed the opportunity to lock in high yields, since IG grade itself will by then be offering lower yields.

 

Certainty on rates is certainly a positive

Investors prefer certainty; over the past two years, the lack of clarity over the trajectory and pace of interest-rate movements has contributed to significant volatility in bond markets. Central banks’ projections of falling rates through 2024 mean investors are no longer waiting to potentially benefit from further rises; with rates set to fall, they will be more prepared to put their money to work now. Similarly, with central banks clearly signalling that rates have stabilised and are set to go down, companies are able to predict their future funding costs with more confidence and time refinancing accordingly (assuming their financial situation allows this).

 

Credit counts

Overall, we see idiosyncrasies rising in the coming months. As a result, fundamental credit analysis will count. It is worth keeping in mind the traditional fixed income mantra: ‘all we do is get our money back’. The best way to outperform is therefore to avoid defaults, material downgrades and resultant forced selling. With this in mind, we emphasise the need for greater selectivity, based on the cashflow visibility and refinancing needs of companies.

Our approach is to be cautious on lower-rated companies with identifiable issues; for example, a firm focused on a single product that may face a significant drop in demand, or whose entire capital structure is due for refinancing in the next 12 months. This does not necessarily mean considering only the best quality credit or ignoring cheaper bonds, but instead focusing on the best combination of risk and reward. The outlook for falling rates should be factored in, along with the points at which refinancing will be due.

Here, another investment mantra comes to mind: ensure you understand the risks you are taking, and that you are being compensated for them.

 

Source.

4. Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document.

Buy the product, not the article

	Ashton Parker Senior Portfolio Manager and Head of Credit Research
	Christelle Curt-Cognac Client Portfolio Manager

 

Need to know:   Markets dislike uncertainty, so a lack of clarity around plans to revise the regulatory regime for sustainable investment funds in the European Union is causing some disquiet among investment firms and industry bodies In the long term, a regime involving clear sustainability-related disclosures throughout the investment chain is needed. But in the meantime, we believe investors should understand the process behind asset managers’ sustainable-investment decisions rather than rely on a specific classification As labelling discussions continue, we believe our research-driven approach to net-zero investing will suit investors aiming to align portfolios with the Paris Agreement

 

Growing pains for going green

If sustainability, as an investment theme, had a painless birth and a relatively carefree childhood, it is certainly having a difficult adolescence. Back in our Q4 2021 edition of Alphorum, we commented on the publicity surrounding former BlackRock CIO of Sustainable Investing Tariq Fancy’s “The Secret Diary of a 'Sustainable Investor'”. Since then, a politically charged debate has ensued around the ESG acronym, especially in the US. As a result, many in the industry are moving away from using ESG as a general descriptor for their investment approach or specific products.

In Europe, clear political, regulatory and investor support has helped keep sentiment towards sustainability generally more positive. However, if there’s one thing markets dislike it is uncertainty. In the view of some stakeholders, some of the uncertainty facing sustainable investors at this point in time comes less from the market or the assets than from regulatory issues – specifically, the European Commission’s ongoing consultation on the future of the Sustainable Finance Disclosure Regulation (SFDR).

A question raised during the EU consultation on SFDR with the investment industry posited whether the regulation’s Article 6, 8 and 9 product classifications should be replaced with three distinct sustainable product labels – ‘transition’, ‘sustainable’ and ‘sustainable impact’ –has been met with concern from investment firms and industry bodies. Overall views vary, with others, including the Irish regulator, suggesting a product labelling regime could run in parallel with the disclosure regime. However, the fundamental concern expressed by stakeholders is that any amendments to the regulations may necessitate a change in investment approach for funds that have been specifically designed to meet the existing classifications.

 

Focus on sustainable-investment convictions first, labels second

At LOIM, we strive to build the research and portfolio-management expertise required to strongly align with the sustainability transition and harness the growth opportunities it is generating.

SFDR is a transparency framework, explaining how financial-market participants must disclose sustainability information so that investors can make well-informed decisions and properly assess how sustainability risks are integrated into investment decisions. Another outcome is that it addresses the risk that investment firms were capitalising on a popular trend, therefore helping to formalise the business of sustainable investment. While article 2 (17) of SFDR clearly defines what constitutes a sustainable investment and requires strategies to be classified as either Article 6, 8 or 9 products, the regulation leaves it to asset managers to interpret and apply these criteria. A range of outcomes has ensued.

Our view is that focusing solely on the requirements for an Article 9 fund, where sustainable investment is the uncompromising objective, as a basis for sustainable allocations has limitations and can result in unintended consequences. Currently, financial-market participants have different interpretations of what constitutes a sustainable investment under SFDR, potentially creating situations where one asset manager’s Article 9 fund is another’s Article 8. This leads us to the view that investors should investigate portfolios to develop their own conclusions about whether strategies are sustainable, rather than place complete confidence in managers’ classifications. 

We believe that truly sustainable investing should focus on two aspects: first, the need to align with, and help finance, the sustainability transition; and second, to develop convictions about which companies or assets are both driving and financially benefiting from this structural economic change.

Investing in a time of climate change places many investors in interesting situations. Some seek to capture growth opportunities generated by decarbonisation solutions and to avoid stranded assets in the fossil-fuel economy; others aim to show regulators that they are factoring climate risk into their portfolios. Fundamentally, rather than products with different classifications, investors need solutions that meet their convictions or disclosure needs.

Our TargetNetZero fixed-income strategy seek long-term alignment with the Paris Agreement.⁵ Using our proprietary implied temperature rise (ITR) methodology, we invest across all sectors in the economy – including materials, utilities and other hard-to-abate industries – in companies whose decarbonisation plans and progress align with a net-zero economy by 2050. Given this emphasis on future emission reductions, we favour high-emitting companies on credible decarbonisation trajectories – the ‘ice cubes’ – over their opposites, the ‘burning logs’, while diversifying the portfolio with exposures to other firms whose credit and climate metrics support our investment aims. 

 

FIG 5. TargetNetZero’s global universe, showing ‘ice cubes’, low-carbon companies and ‘burning logs’ identified by our research

Source: LOIM at January 2023.

 

This forward-looking approach, which supports decarbonisation where it is needed most, contrasts with competing strategies based solely on current carbon footprints. Such products, in our view, are weighted towards low-emission sectors like healthcare and IT, creating concentration risks in portfolios while not supporting decarbonisation in hard-to-abate industries.

Despite their undeniable climate focus, we categorise our TargetNetZero strategy as an Article 8 product. Although one of its core objectives is to align with the Paris Agreement and the strategy commits to a 10% allocation to sustainable investments corresponding with the activities specified by the EU Taxonomy, for diversification purposes the strategy holds positions in the debt of companies whose activities do not meet the definition of sustainable investment under SFDR. Yet we invite investors to understand look under the hood of the portfolios to consider the potential net-zero-alignment, diversification and performance merits it offers.

 

The future looks bright, the future still looks green

Looking beyond the debate about product classification, the global sustainability wave continues to build momentum. While polarising references to phasing out fossil fuels were avoided, the UAE Consensus agreed at COP28 nevertheless sets down in black and white a global commitment to shift away from oil and gas in a “just, orderly and equitable manner”. It also commits to accelerating action this decade by tripling the global commitment to renewable energy capacity and doubling the global rate of energy efficiency by 2030. All of this provides strong tailwinds for the net-zero transition.

Admittedly, sustainable investing is still far from being an exact science. As a young discipline relative to other investment approaches, there has so far been little opportunity to back-test analytical models. HoweverLOIM is developing track records : in the coming months, our TargetNetZero strategies will join some of our sustainable equity solutions that have marked three-year anniversaries, and we will look back on their performance in a future edition of Alphorum.

In the long term, we believe there is a need for a regulatory approach that involves clear sustainability-related disclosures throughout the investment chain – from the companies themselves, through fund managers and to asset owners such as pension funds, insurers and financial institutions. However, even after clarifications are made, we will continue our research-driven, high-conviction approach to sustainable investing.

In 2024, the investment focus of our TargetNetZero strategies will continue to be on identifying ice cubes with attractive credit profiles. This is where combining our experience in ITR with fundamental credit analysis comes into its own.

 

Source.

5. Target performance is an estimate of future performance based on current market conditions and are not an exact indicator. What you will get will vary depending on how the market performs and how long you keep the product.

The impact of term premia on credit performance

	Anando Maitra, PhD  Head of Systematic Research and Portfolio Manager
	Jamie Salt  Systematic Fixed Income Analyst and Portfolio Manager

 

Need to know: An aspect we have referred to in recent systematic research commentaries for Alphorum but not explored in depth is term premia: a measure of the excess return of a fixed-coupon government bond over the risk-free cash rate Our analysis shows that the low Sharpe ratio of US Treasuries, and by extension investment-grade credit, in periods of low term premia indicates the need for an exposure to credit risk in the current environment Selectively moving down to the BBB to BB ratings segment (often called the crossover market), offers appealing structural characteristics and access to positive carry over cash, while avoiding the fundamental minefield in the lower end of high yield

 

In light of the new regime of higher yields and greater volatility in fixed-income markets, our recent Alphorum contributions have explored the drivers of expected return in the asset class. Our intention has been to encourage the grounding of medium-term allocation decisions while macro uncertainty and noise is elevated.

One element we have often referenced but until now not explored rigorously is term premia. These are a measure of the excess return of a fixed-coupon government bond over the risk-free cash rate, and represent compensation for uncertainty in future inflation and real rates. In this analysis, we will examine how the level of term premia impacts performance across fixed-income segments, and demonstrate that in the current environment IG corporate bonds are less appealing from an expected return perspective. Building on this, we will then present a scenario analysis framework for 2024. 

 

Rate vs credit returns

As we outlined in the previous issue of Alphorum, IG issuers are generally expected to weather the rise in funding costs better than HY issuers thanks to a vastly superior fundamental position. However, this is primarily a credit-based argument. In practice, IG bond returns tend to be dominated by rates (duration) while HY performance is driven by credit risk (see 6). But the crossover segment – bonds rated BBB to BB – tends to produce an even balance between the two.

 

FIG 6. Percentage split between rates and credit for a) return and b) risk, 2004-2023

Source: LOIM, Bloomberg indices. As of 29 December 2023.

 

Credit return and risk are generally well understood and are dependent on the level of credit spreads, with an adjustment for defaults. In addition, the mean-reverting nature of credit spreads indicates that long-term volatility and return can be estimated reliably. However, an estimate of the return from rates is much more difficult. One approach followed in the literature is the use of Treasury term premium models such as the Adrian, Crump and Moench (ACM) model of the Federal Reserve Bank of New York.⁶ Term premium largely measures the expected excess return of a Treasury bond over cash, and is estimated using the historical relationship of excess returns with the shape of the curve (pricing factors) and changes in the shape of the curve (factor innovations).

 

Term premia regimes

The ACM term premium model shown in Figure 2 indicates that the term premium for Treasuries, while having corrected in September and October 2023, has returned to below zero for the five- and 10-year points. This indicates that the long-term expected return over cash remains negative for Treasuries. Note again that interest rates are a key driver of risk and return for IG, indicating a large source of risk that has limited long-term performance benefits.

 

FIG 7.  ACM term premium model for 5-year and 10-year US Treasuries, 1983-2023

Source: Adrian, Tobias, Richard K. Crump, and Emanuel Moench. ‘Pricing the term structure with linear regressions’. Published in the Journal of Financial Economics 110, No. 1 (2013): pp110-138.

 

Indeed, by calculating the risk-adjusted performance of various fixed-income segments since 1983, based on the level of the term premium,⁷ we can see that this translates into realised performance (see figure 8). The results clearly show that the risk-adjusted performance of IG corporates is significantly worse than for HY issuers in periods of low term premia, dragged further down by poor Treasury performance.

 

FIG 8. The Sharpe ratio is conditional on levels of 10-year term premia for US Treasuries, IG, crossover and HY, 1983 - 2023

Source: LOIM, Bloomberg indices. As of 29 December 2023.

 

Although the fundamental ‘safety’ of IG seems appealing in times of uncertainty, the low Sharpe ratio of IG credit in periods of low term premia indicates the need for an exposure to credit risk in the current environment. While credit fundamentals are likely to worsen, especially for lower rated issuers, we believe that staying within the crossover rating segment of BBB and BB can provide the desired mix of credit and rate risk going forward. This is backed up by the findings of our analysis, with crossover acting as the sweet spot through both regimes.

 

The ‘breakeven’ yield change buffer

Another way to expose the detrimental impact of negative term premia on rate performance is by calculating the change in yields required over the subsequent 12 months for returns to fall below a given boundary. Effectively, this is the ‘buffer’ that carry-based income provides in the event of falling price levels (or rising yields). We refer to this as the ‘breakeven’ yield change.

In figure 9, we show the breakeven yield change required for US IG and HY to post returns that are less than zero and below cash. We can see in the left chart that to avoid negative returns in both segments, there is a sizable buffer well above recent low levels and nearer long-term averages. While this level reflects the heightened yield environment, it hides the impact of negative term premia. Setting the breakeven benchmark to cash in the right chart incorporates the effect of negative term premia; we can see that the buffer disappears in the IG space, meaning that to outperform cash, yields need to fall. In contrast, for HY, while the buffer has fallen recently, it is well above the lows of 2006 to 2007, providing a cushion of about 75bps of higher yields before the asset class would underperform cash. To us, this emphasises the need for a balanced HY exposure in current market conditions in order to access carry over cash.   

 

FIG 9. Breakeven yield change for US investment grade and high yield to post returns below a) zero and b) cash

Source: LOIM, Bloomberg indices. As of 29 December 2023. For illustrative purposes only.

 

What does this mean for 2024 performance?

To contextualise how this could translate into performance, figure 10 presents total return estimates for global IG and HY indices over the coming 12 months, across a range of rate (vertical) and spread (horizontal) scenarios. The impact of the additional breakeven yield change cushion in HY is evident in the lack of negative returns in the scenarios presented. However, in IG, a move back towards 5% in 10-year US yields would almost certainly mean negative returns. If we then take the current 12-month US treasury rate of 4.78%, we can see the impact of the reality of the breakeven yield versus cash numbers as presented in figure 9, with any move higher in rates essentially translating to returns below cash in IG. The only scenarios in which IG grade is better off than HY is in the event of substantially lower rates and much wider spreads, which is the sort of move we would expect to see in a growth-related downside shock. Such a scenario is one which advocates for a duration allocation.

 

FIG 10. Scenario analysis: global corporate bond indices on a 12-month-ahead total return basis, at different interest rates (USD-hedged)

	Investment grade: % change in spreads, from 29 December 2023
US/DE rates	-30%	-15%	0%	15%	30%
3.00/1.58	10.4	9.7	9	8.1	7.3
3.50/1.83	7.9	7.2	6.5	5.7	4.8
4.00/2.08	5.5	4.8	4.1	3.2	2.4
4.50/2.33	3	2.3	1.6	0.8	-0.1
5.00/2.58	0.5	-0.2	-0.9	-1.7	-2.5

 

	High yield: % change in spreads, from 29 December 2023
US/DE rates	-30%	-15%	0%	15%	30%
3.00/1.58	10.9	9.7	8.6	7.1	5.7
3.50/1.83	9.8	8.6	7.4	6	4.6
4.00/2.08	8.6	7.4	6.2	4.8	3.4
4.50/2.33	7.4	6.2	5	3.6	2.2
5.00/2.58	6.2	5	3.9	2.5	1

Source: LOIM, Bloomberg Barclays indices. As of 29 December 2023. For illustrative purposes only.

 

Conclusion

Ultimately, although heightened yields (at least by recent standards) and robust fundamentals make IG appealing, the reality of forward-looking returns in a world of negative term premia means that, in our view, selectively moving down the ratings spectrum is preferable. The crossover segment offers appealing structural characteristics, and with our current outlook it also appears tactically appealing, too. This is because it provides the best spot to access positive carry over cash across a range of scenarios, while avoiding the fundamental minefield in the lower end of high yield.

 

Sources.