Insight Investment

The conflict in the Middle East has pushed up absolute yields in investment grade credit, and we believe this presents an opportunity to add to US credit holdings. Fundamentals remain resilient, with double digit earnings growth and elevated levels of supply being met by strong demand. Although we’re wary that M&A risks are rising at this point in the cycle, we believe free cash flows are high enough to offset an upward creep in leverage levels.

With growth concerns elevated, municipal bonds have been caught up in broader market volatility, pushing absolute yields higher. Those sectors exposed to higher energy costs have moved into focus, including airports, toll roads, seaports and utilities. When selling becomes indiscriminate, fundamentals are often ignored. This is an ideal backdrop for active investors with strong credit research teams who can hunt out issuers offering robust liquidity and operating flexibility even in a world of higher energy prices.

The US dollar rallied sharply as conflict erupted, drawing on its traditional safe haven appeal and reminding investors how quickly markets can reprice under stress. However, the move proved tellingly short lived. On approaching recent highs, the currency struggled to sustain momentum. In our view, while geopolitical shocks may trigger temporary surges, they are unlikely to reverse the broader trend which is a gradual drift back toward fair value as investors diversify after years of heavy concentration in dollar assets.

The European growth renaissance story has clearly been challenged by the energy price shock, prompting us to downgrade our growth forecasts for 2026 and 2027. A prolonged period of elevated energy costs now raises the possibility that the ECB could be forced into rate hikes, even as underlying growth momentum weakens. Paradoxically, that risk leaves us more constructive on European bonds further out the curve, particularly around the five and ten year mark, where higher short term rates could ultimately amplify growth concerns and support duration.

Volatility following Middle East tensions prompted a sharp repricing of rate risk in fixed income markets as sharp moves in energy prices weighed on inflation expectations and government bond yields. We responded by rotating duration exposures, closing our long in Germany as markets moved to price further rate hikes, and switching into long US duration where we believed the risk of rate cuts was being underpriced.

When we look at forward pricing, Australian fixed income markets are effectively discounting a terminal policy rate of between 4.5 to 5% indefinitely, compared with closer to 3.5% in the US. That divergence looks difficult to justify. In our view, it is Australia where expectations are most stretched. Recent data points to an economy that is already softening, suggesting that current rate assumptions are unlikely to be sustained. This leaves us constructive on Australian bonds on a relative value basis.

In a risk off environment marked by spread widening and reduced liquidity, European ABS is demonstrating its defensive characteristics, benefiting from the typically more senior, shorter dated nature of the exposure. Volatility creates opportunities to reallocate capital into situations which we believe offer more attractive risk return characteristics. Wider spreads allow us to add selectively across both primary and secondary markets, incrementally adding to yield while maintaining overall credit risk exposure at a comparable level.

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