Fold
Should investors “fold” on the view of a recession, appreciating that greater use of fiscal policy and significant central bank liquidity will continue to support markets and economies?
Walk away
Should investors “walk away,” adopting the view that the economic outlook isn’t as important to financial markets as it once was, given the impact of central bank liquidity?
Run
Should investors “run,” given even looser fiscal policy could (re)ignite concerns regarding inflation and very stretched government debt levels, sparking market volatility?
Brett Lewthwaite
CIO and Head of Fixed Income
- Economic downside risk remains elevated, and as such we remain in a prudent and cautious investment position.
- Our focus remains on maintaining elevated levels of liquidity and a defensive mindset favouring duration, which provides attractive yields and a risk offset, along with high quality investment grade credit, which we expect to be less impacted should we see volatility arise.
- We stand ready to lean into markets more heavily should we see valuations become more attractive and will actively seek out individual pockets of opportunity and value that remains across markets.
- Yield levels remain elevated compared to historical levels following an aggressive monetary policy tightening cycle, and central banks globally have likely reached the end of their policy tightening cycle; therefore, we see value in having duration exposure.
- Rates exposure remains our preferred expression of our investment outlook. We will look to add duration should yields pick up. However, this will be more nuanced in regards to timing, as market pricing of cuts and supply dynamics will likely have an impact on the volatility in the shorter term.
- We favour the front and middle of curves to position for the end of the hiking cycle.
- Credit fundamentals continue to be finely balanced though with some level of deterioration expected as we head later in the credit cycle.
- We remain cautious on the sector as a whole. All-in yields in credit markets are providing a compelling return proposition; however, credit spreads do not reflect the backdrop of heightened market volatility and the uncertain economic outlook.
- We see opportunities in select names and have a preference for short-dated investment grade exposures. Within higher beta sectors, we prefer high yield over loans, noting that high yield generally performs well after rate pauses. However, we remain patient for appropriate entry levels.
- The global backdrop continues to be the main driver for the asset class, with spreads on hard currency debt at fairly tight levels, though they are in line with global credit equivalents.
- EM currency performance is dependent on USD trajectory, and we await more attractive conditions to increase local currency exposure. Technical support is evident with increased interest into the asset class and relatively under-invested crossover, which could be a positive factor going forward.
- We maintain a neutral view but are taking a selective approach to opportunities, particularly within BB rated, which offers more opportunities.
- US agency mortgage-backed securities (MBS) remains our favoured exposure within the structured products market. It continues to exhibit favourable valuations with underlying US housing market fundamentals still resilient.
- Australian residential MBS spreads are at wides of historical ranges, which we see as attractive, though we are concentrating on higher-quality transactions, which are backed by robust structures.
- We remain defensive within commercial MBS as commercial real estate fundamentals will be slow to recover and expect loan delinquencies to trend higher.
- USD – likely at structural peak but will be a slow downward trend, prone to volatility as the market’s focus shifts between recession and disinflation.
- EUR – a weaker growth story and higher inflationary risks from geopolitical events is likely to weigh on valuations.
- AUD – we are cautiously optimistic, as we expect rate differentials to move in its favour. It also looks cheap from a valuation perspective.
- JPY – with the Bank of Japan the only G10 central bank yet to tighten policy, we favour buying JPY on dips, although carry remains a drag.
Previous Fixed Income Strategic Forum insights
One of the challenges with investment management is balancing the short-term noise of financial markets with a longer-term assessment of the investment and economic landscape. The Fixed Income Strategic Forum is held three times a year, comprising more than 130 investment professionals, and operates to establish our medium-term views and strategic portfolio positions. Check out our previous Strategic Forum insights below.
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Fixed income securities are subject to credit risk, which is the risk of loss of principal or loss of a financial reward stemming from a borrower’s failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises whenever a borrower expects to use future cash flows to pay a current debt. Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation. Credit risk is closely tied to the potential return of an investment, the most notable being that the yields on bonds correlate strongly to their perceived credit risk.
Fixed income securities are also subject to interest rate risk, which is the risk that the prices of fixed income securities will increase as interest rates fall and decrease as interest rates rise. Interest rate changes are influenced by a number of factors, such as government policy, monetary policy, inflation expectations, and the supply and demand of securities. Fixed income securities with longer maturities or duration generally are more sensitive to interest rate changes.
Fixed income securities may also be subject to prepayment risk, which is the risk that the principal of a bond that is held by a portfolio will be prepaid prior to maturity at the time when interest rates are lower than what the bond was paying. A portfolio may then have to reinvest that money at a lower interest rate.
Market risk is the risk that all or a majority of the securities in a certain market – like the stock market or bond market – will decline in value because of factors such as adverse political or economic conditions, future expectations, investor confidence, or heavy institutional selling.
Natural or environmental disasters, such as earthquakes, fires, floods, hurricanes, tsunamis, and other severe weather-related phenomena generally, and widespread disease, including pandemics and epidemics, have been and can be highly disruptive to economies and markets, adversely impacting individual companies, sectors, industries, markets, currencies, interest and inflation rates, credit ratings, investor sentiment, and other factors affecting the value of the Strategy’s investments. Given the increasing interdependence among global economies and markets, conditions in one country, market, or region are increasingly likely to adversely affect markets, issuers, and/or foreign exchange rates in other countries. These disruptions could prevent the Strategy from executing advantageous investment decisions in a timely manner and could negatively impact the Strategy’s ability to achieve its investment objective. Any such event(s) could have a significant adverse impact on the value and risk profile of the Strategy.
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Currency risk is the risk that fluctuations in exchange rates between the US dollar and foreign currencies and between various foreign currencies may cause the value of an investment to decline. The market for some (or all) currencies may from time to time have low trading volume and become illiquid, which may prevent an investment from effecting positions or from promptly liquidating unfavourable positions in such markets, thus subjecting the investment to substantial losses.
Credit risk is the risk of loss of principal or loss of a financial reward stemming from a borrower’s failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises whenever a borrower expects to use future cash flows to pay a current debt. Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation. Credit risk is closely tied to the potential return of an investment, the most notable being that the yields on bonds correlate strongly to their perceived credit risk.
Mortgage-backed (MBS) and asset-backed (ABS) securities, like other fixed income securities, are subject to credit risk and interest rate risk, and may also be subject to prepayment risk and extension risk. Extension risk is the risk that principal on mortgage-backed or asset-backed securities will be repaid more slowly than expected, which may reduce the proceeds available for reinvestment in higher yielding securities. MBS and ABS may decline in value, become more volatile, face difficulties in valuation, or experience reduced liquidity due to changes in interest rates or general economic conditions. Certain MBS or ABS, such as collateralized mortgage obligations, real estate mortgage investment conduits, and stripped MBS, may be more susceptible to these risks.
Inflation is the rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. Central banks attempt to stop severe inflation, along with severe deflation, in an attempt to keep the excessive growth of prices to a minimum.
Liquidity risk is the possibility that securities cannot be readily sold within seven days at approximately the price at which a fund has valued them.
The global financial crisis (GFC) refers to the period of extreme stress in global financial markets and banking systems between mid-2007 and early 2009.
Gross domestic product (GDP) is a measure of all goods and services produced by a nation in a year. It is a measure of economic activity.
Quantitative easing (QE) is a government monetary policy used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increased the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.
Quantitative tightening (QT) refers to when central banks raise interest rates. In a tightening monetary policy environment, a reduction in the money supply is a factor that can significantly help to slow or keep the domestic currency from inflation.
Recession is a period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in GDP in two successive quarters.
A Treasury yield refers to the effective yearly interest rate the US government pays on money it borrows to raise capital through selling Treasury bonds, also referred to as Treasury notes or Treasury bills depending on maturity length.
The yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the 3-month, 2-year, 5-year, and 30-year US Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. It is also used to predict changes in economic output and growth.
The shape of the yield curve is closely scrutinized because it helps to give an idea of future interest rate change and economic activity. There are three main types of yield curve shapes: normal, inverted and flat (or humped). A normal yield curve is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time. An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields, which can be a sign of upcoming recession. A flat (or humped) yield curve is one in which the shorterand longer-term yields are very close to each other, which is also a predictor of an economic transition. The slope of the yield curve is also seen as important: the greater the slope, the greater the gap between short- and long-term rates.
Yield curve inversion is when coupon payments on shorter-term Treasury bonds exceed the interest paid on longer-term bonds.
The Consumer Price Index (CPI) is a measure of inflation representing changes in prices of goods and services purchased for consumption by households.
The S&P 500 Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the US stock market.
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