Yields have reached levels that should offer protection from future volatility and provide income.
By Erick Muller, Director Product and Investment Strategy, and Tatjana Greil-Castro, Co-Head Public Markets, Muzinich & Co.
It has been a tough year for global fixed income, as rising inflation and interest rates, combined with elevated geopolitical tensions, weighed on all sub-asset classes.
However, the benefit of a reversal in the direction of interest rates is that the landscape for savers has changed and income from credit is back.
Rapidly Rising Rates
By the end of September, global corporate bond markets had fallen nearly 20 percent; two-thirds of the negative performance came from rising interest rates, with only one-third from spread widening.
Central banks have been forced to raise rates due to the rapid rise in inflation post-Covid, a trend we believe is likely to continue into early 2023 on both sides of the Atlantic.
While great uncertainties remain, we are unlikely to see a repeat of 2022 in terms of price action given the closer alignment of central banks and market participants. As such, we believe a very significant rate tightening is already included in the current price of short-term forward rates.
Corporate Fundamentals Remain Resilient
Significant spread widening in investment grade and high yield has increased the premia over government bonds, reflecting the deteriorating macroeconomic backdrop, compressed corporate margins and lower global liquidity. With spreads meaningfully above their five-year average, we believe they are incorporating a «mild recession» premium.
However, corporates appear in reasonably good shape. Defaults are unlikely to match previous recession cycles given refinancing needs were largely met in 2021 while high-yield companies have much stronger balance sheets following post-Covid measures.
Energy prices are also high which should prevent energy companies from contributing to defaults as in previous downturns. Nevertheless, the market is currently pricing in a 44 percent cumulative default rate over the next five years, a level we believe is overdone.
Improving Valuations
In our view, the combination of higher yields and wider spreads has significantly improved valuations, changing the total return for credit. For years savers faced very low all-in yields, yet today an allocation to a global credit market average investment grade solution with limited interest rates sensitivity is now able to offer a gross yield in euros above 5 percent.
The new fixed-income valuations allow yields to act as a shield against future volatility in financial markets. The mechanism is simple - the current yield would need to be erased before the investor loses money.
In fact, some simulations made at end of September showed that a similar rise in yields and spreads seen so far this year would not incur losses should an investor allocate into a global crossover mandate based on a portfolio comprising 60 percent global investment grade corporates and 40 percent global high yield.
Income is Back
The «income» in fixed income is back, and investors willing to protect their savings portfolio from excessive financial market volatility should no longer ignore the opportunities in global credit markets after a prolonged period of poor returns.
For medium-term investors
In our view, current valuations offer an attractive and predictable revenue stream for medium-term investors, and it is time to enjoy it.
Erick Muller is Head of Product and Investment Strategy at Muzinich & Co. He is responsible for strategy and product management as well as client relationships between institutions, global distribution platforms and global private banks. Muller holds an MBA in Finance and Marketing from ESLSCA Business School and a degree in Economics from Université Panthéon-Assas.
Tatjana Greil-Castro is Co-Head Public Markets at Muzinich & Co. and manages the Muzinich Enhancedyield Short-Term strategy and the Muzinich Sustainable Credit strategy. She has a Ph.D. from the London School of Economics, a Masters from the Kiel Institute of World Economics in Germany and an M.Sc/B.S. in Economics from the University of Vienna.
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