Three Reasons Why the Fixed Income Environment May Be Better Than You Think
By: Martin Horne, Barings
For fixed income investors worried about wider credit spreads and an imminent wave of defaults, assessing the overall level of risk-reward on offer may help allay concerns. Despite the prevailing negativity, fixed income currently offers a range of compelling opportunities. Here are three reasons why.
This is an excerpt from NCPERS Summer 2023 issue of PERSist, originally published July 18, 2023.
For fixed income investors worried about wider credit spreads and an imminent wave of defaults, assessing the overall level of risk-reward on offer may help allay concerns. Despite the prevailing negativity, fixed income currently offers a range of compelling opportunities. Here are three reasons why:
1. The Long-Anticipated Downturn
While certain countries such as Germany have technically already entered a recession, other major economies such as the U.S. may not follow until later in 2023 or early 2024—arguably making it one of the most widely anticipated downturns in recent history. That has given companies considerable time to prepare. Corporate management has been managing costs closely and keeping inventory levels low. Many companies have also reduced leverage levels and proactively increased the maturity profile of their debt. As a result, any earnings decline that occurs as growth slows is likely to be orderly, while default rates could be lower than in previous downturns. Indeed, high yield issuers are in a stronger financial position to ride out challenges than they were pre-pandemic. The credit quality of the global high yield bond market has also improved considerably since the global financial crisis.
Figure 1: A Higher-Quality Market
Source: Bank of America. As of March 31, 2023.2. Dislocations Create Opportunities
While recent banking problems are more a result of declining market values for high-quality bank assets than of lax lending standards, banks are now more cautious. But fears among public fixed income investors that tighter and more expensive bank credit could trigger liquidity problems for borrowers in public markets may be overblown. Perhaps counterintuitively, bank tightening could benefit investors in credit markets—both public and private. Opportunities to finance healthy companies that would otherwise have tapped banks are likely to increase and with supply/demand dynamics moving in favor of lenders, investors can expect to earn not only attractive yields but do so with added structural protections. In essence, providing capital when capital is scarce can be an attractive source of returns for investors willing to take smart credit risk—even into a downturn.
3. Yields Offer a Considerable “Margin of Safety”
With current prices reflecting much of the uncertainty and volatility, yields across most fixed income assets are at levels not seen since the global financial crisis (aside from the depths of the pandemic). This offers the potential for higher and more dependable absolute returns than many other asset classes.
At Barings, we advocate for patient investing and diversification in helping our clients solve for challenges ranging from income generation to liability matching. Fortunately, there are more choices today than ever before to help achieve this—from corporate and sovereign bonds (both high yield and investment grade) across developed and emerging markets, to floating-rate loans, collateralized loan obligations and various flavors of asset-backed securities. In our view, for investors who keep a level head, environments like today's can offer some of the best long-term opportunities for total returns.
About the Author: Martin Horne is Barings' Global Head of Public Assets, which incorporates the global high yield, investment grade, structured credit, equities, emerging markets corporate debt and global sovereign investment teams. Martin is also Chairman of the European High Yield Investment Committee and Chairman of the Global High Yield Allocation Committee. He is also an Executive Sponsor of the Barings Black Talent Network employee resource group, as well as the Charter for Black Talent in Finance and the Professions in the U.K. Martin has worked in the industry since 1993 and his experience has encompassed the mid cap, structured credit, investment grade and leveraged finance markets. His roles at Barings also incorporated roles as senior portfolio manager in cornerstone strategies, and head of research for the European High Yield Group. Martin previously served on the board of directors of the Loan Market Association and holds a B.A. in Economics from Reading University.