Treasuries to stabilise amid aggressive Fed hiking
Last week brought a fresh bout of wild swings in both the rates and equity market. Central bank meetings from the prior week failed to fill market participants with any confidence or conviction leaving investors facing a mental tug of war between inflation and recessionary fears. It will take some time before the market has any clarity on whether inflation trumps growth or vice versa, so in the near term we can expect this level of volatility to persist.
Given this challenging market backdrop, we believe that short-dated investment grade is an attractive proposition that is often overlooked.
As financial conditions tighten and consumer balance sheets are stretched it is only natural that we should expect an uptick in the default rate, with the magnitude largely dependent on central bankers ability to control inflation and engineer a soft landing. Thus, at this stage in the economic cycle we believe it is prudent to allocate to strong, defensive investment grade (the 1 year investment grade default rate was 0.1% in Moody’s latest default study) companies with strong pricing power and a balance sheet that can weather an economic downturn. Utilities and telecoms are great examples of such non-cyclical companies, both of which typically have inflation linked revenues built into their customer contracts. Given these characteristics it’s easier to become comfortable with the bottom-up fundamentals.
Is there value in Investment Grade?
Rates curves have steepened and credit spreads have moved significantly this year. Short dated investment grade now looks very attractive, the ICE BofA 1-3yr BBB GBP Corporates index has widened 105bps from the start of the year to 214bps and is now yielding 4.16%, more than double its duration. Credit spreads may well remain under pressure for the remainder of the year, and potentially into 2023 as central banks remove their purchasing programs and shift to QT. Ultimately however, as short dated bonds rapidly move closer to maturity pull to par will dominate any wider economic strain on spreads and when principal is repaid, the purchased yield is achieved. If you can look through any short term volatility you can still be confident investing in this part of fixed income despite the challenging economic backdrop.
What about rates? Break-evens are your friend!
Markets are currently pricing in a significant number of interest rate hikes over the next 6 months - a further 6.7 hikes from the BoE and around 7.4 from the Fed. The market may well price in additional hikes if inflation remains elevated and central bankers take a more aggressive stance. Further rises in rates would imply negative price action for bonds, however that doesn’t necessarily mean negative total returns if you pick the right bonds. High break-even bonds (break-even being the amount yields need to rise before carry is wiped out by capital losses) offer significant protection in a highly uncertain interest rate environment. Let’s take a non-cyclical strong investment grade example, National Grid 5.875% maturing in February 2024 currently yielding 3.3% in GBP has a breakeven yield of 8.7% meaning its yield can increase up to 5.4% before total returns are negative. Whilst it is not impossible, it is incredibly difficult to imagine an almost default risk free bond maturing in less than 2 years yielding 8.7% - we think everyone would be a buyer there. There are plenty of examples of bonds at the front end of the curve offering more protection than you may initially think. The steepness of the curve means returns of 3-4% are not unfeasible, while benefiting from roll-down and reinvestment opportunities at higher yields when bonds mature.
While we cannot predict the path for interest rates or credit spreads, high break-evens can protect you from upward moves in yields amidst this highly uncertain market. In a world where equities could go anywhere, we believe that if you are able to weather any potential short term volatility you can make some very attractive returns in this part of fixed income.