Credit Insights: The revival of fixed income | Insight Investment | Insight Investment

Contents

• Our final verdict on our 2022 calls
• Our key macro call for 2023: US exceptionalism but persistent high rates
• Our key investment call for 2023: High rates will make this a fixed income era
• Insight's 2023 calls summarized

Our final verdict on our 2022 calls

Macro calls

We underestimated inflation last year, in terms of severity and persistence as “sticky” services sectors like rents accelerated. The Ukraine war also played a part, but to a lesser extent than for inflation abroad. It forced the Federal Reserve and other central banks to be more inflation-focused than we had expected, taking away the “easy policy” punchbowl.

Table 1: Inflation figures were higher than we expected

Source: Bloomberg US High Yield Corporate Index, ICE US Convertibles Index, JP Morgan Corporate EMBI Global Index, JP Morgan EMBI Global Sovereign Index. Bloomberg EM Hard Currency Index, December 2022.

Investment calls

Nonetheless, many of our investment calls were accurate. We expected equities to struggle as financial conditions tightened. We also expected to find compelling opportunities to lock in income opportunities, such as in high yield (albeit entering in early 2022 would have been too early). Emerging markets, however faced a far tougher year, with a strong dollar, the Ukraine war and Chinese lockdowns having a marked effect.

Table 2: Our investment calls nonetheless fared well as we anticipated tighter financial conditions

Source: Insight, January 2023. Opinions expressed herein are as of the date of this presentation, and are subject to change without notice. Insight assumes no responsibility to update such information or to notify a client of any changes.

Our key macro call for 2023: US exceptionalism but persistent high rates

The US looks attractive versus the rest of the world

We believe the United States is potentially about to see a resurgence of global industrial production over the next decade. Any New Yorker taking a road trip along the Eastern Seaboard would have noticed miles of factory construction sites along the North Carolina to West Virginia corridor.

Figure 1: US manufacturing is on the rise

Source: Reshoring initiative, ZETA, SIA and Alliance for Automotive Innovation. Note: Initial snapshot of some of the companies announcing major investments in the US since 2021. The mention of a specific security is not a recommendation to buy or sell such security. The specific securities identified are not representative of all the securities purchased, sold or recommended for advisory clients. It should not be assumed that an investment in the securities identified will be profitable. Actual holdings will vary for each client and there is no guarantee that a particular client’s account will hold any or all of the securities listed.

Multinational corporates are responding to political uncertainty in China, where expanding production has become less workable. The US has emerged as a compelling alternative, partly due to fiscal incentives relating to the administration’s Inflation Reduction Act and Chips and Science Act. Further, the relative stability of energy prices compared to Europe, which has large exposure to Russian supplies, is more appealing to heavy industrials. The West Virginia corridor appears to offer the best combination of resource, weather exposure, educated workforce and labor cost.

Figure 2: Reshoring of corporate supply chains to the US is accelerating

Source: Reshoring Initiative, Q3 2022: https://reshorenow.org/content/pdf/2022_Q3_data_report.pdf

We expect this to boost US GDP and help cushion the US through the upcoming global downturn. This supports our wider view that the US may avoid a recession over the next two years. If not, we believe any recession will be shallow.

It will also complicate the Fed’s attempt to bring inflation back down to target.

We believe markets are wrong about rate cuts coming this year

The Fed’s attempt to slow the economy will not be helped by an influx of industrial production and a US consumer than still has ~$1trn of $2trn of excess savings (amassed during the height of the pandemic) left over¹.

It is well understood that the Fed intends to raise rates to a peak above 5%. However, markets are subsequently pricing in rate cuts later in 2023 after the peak is in. We believe markets are wrong here. We expect rates to remain at the peak levels for the rest of the year, and potentially even all of 2024.

Our key investment call for 2023: High rates will make this a fixed income era

With peak Fed rates arriving and becoming entrenched this year, equity markets will have to wait even longer for the “Fed put” to return as central banks focus on keeping financial conditions tight.

While high rates will make life difficult for equities, it potentially creates a sweetspot for fixed income.

Compelling yields are now achievable on lower and higher risk credit assets. TINA (“there is no alternative”) was an equity story for the last few years, but if anything, it may well be a fixed income story now. At least, TARA (“there are reasonable alternatives” to equities) should be the new watchword.

Investment grade credit looks attractive – particularly the front end: Investment grade credit now offers 4.5% yields, compared to ~2% in 2021². We believe an active approach can push this up to north of 6%. The inverted yield curve offers value at the front end. Floating rate notes also offer an, in our view, outsized premium given forward curve expectations of falling rates later this year.

High yield offers yields in line with growth asset returns: Investors can lock in yields over 8.5% (since 2000, the S&P has averaged a 7.6% pa total return). We estimate that even if index defaults were to rise to 2008 levels, this would still leave the high yield index³ with a comparable yield to BBB credit⁴.

Interest coverage ratios actually improved over 2022 given anaemic supply. ~55% of the bonds in the high yield index were issued in 2020 or 2022 during the era of record low rates, with no significant maturity wall until 2025.

Fallen angels could be a compelling high yield “overweight”. Ratings migration may raise the supply of fresh downgrades to high yield, which become subject to forced selling from investment grade accounts and offer value. We believe investors need access to a strategy than can enhance liquidity in these less liquid markets.

Convertible bonds could be attractive if we are wrong about equities

Our view is that credit will outperform equities, particularly on risk-adjusted basis. However, in case we are wrong, we believe a long-only convertible bond strategy can be a compelling way of playing both sides.

Convertible bonds offer the optionality to convert the debt to equity if stock markets do rally strongly.

On the debt side, convertible bonds yields have gone from close to 0% to ~3%⁵, offering genuine income for the first time in years. If equity markets rally, investors can convert their bonds into equities and participate on the upside. Convertibles have tended to be issued by higher-beta companies from innovative industries that have significant capital needs for investment. As such, when equity markets rally, the equity of the companies that raise convertible debt has historically performed well.

Further, certain issuers may look to refinance their maturing high yield debt in the convertibles market given the lower cost (a result of selling the equity call option to the investor) which may lead to some compelling deals.

Structured credit may also be an option for corporate refinancing

The other way for corporate and other borrowers to refinance maturing debt more cheaply is to offer investors security. This makes structured credit a potential avenue for refinancing.

We continue to see structured credit as attractive, partly given diverse collateral types, structural protections and enhanced spreads, particularly further up the capital structure where we believe distress would be unlikely to inflict losses on investors.

Lastly we continue to see value in private structured credit market segments, particularly esoterics. Given idiosyncratic factors, rigorous credit selection remains critical in this space and we do expect the market to cheapen further from here, making it a potential area for flexible investors to watch.

Table 3: Implications for pension allocations: Flip equity and bond assumptions

Insight's 2023 calls summarized