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Fixed Income investors see light at the end of the tunnel

Financial markets eagerly look beyond the recession. Yet Fixed Income Investors worry about default rates or liquidity. What does the future hold?

December 30, 2022

Andrew Jackson

Head of Fixed Income

We are deeply skeptical about the financial markets’ desire to “see past” the recession and view the world as if it were moving into the sunlit uplands. After many years of central banks implementing the unprecedented and coordinated Zero Interest- Rate Policy (ZIRP) alongside endless rounds of Quantitative Easing (QE), the “come down” feels both painful and protracted. As Fixed Income investors, we are worried about default rates, liquidity, and the loosening of credit terms and leverage over the past few years. We also acknowledge that certain aspects of our Fixed Income universe have further downside risk.

We do, however, believe that Fixed Income, more broadly, and the least risky parts, in particular, present outstanding value for risk for investors both in relative and absolute terms. In fact, we would go as far as to say that as we turn the page on the worst year ever for global Investment Grade Fixed Income and go into another year, there is the chance that 2023 will end up being the best year since 2009 for this particular sub-asset class.

Navigating through Fixed Income markets

This is the first in a series of short updates on Fixed Income markets written by the Credit Suisse Asset Management Fixed Income team. They will be concise, easy to read, focused on Fixed Income, and timely. Most importantly, these updates will express definitive views on Fixed Income markets. I also promise to give you my views through the lens of risk. To that end, I will kick off with my concerns over the short-term path for some of the higher risk parts of our asset class.

  1. While interest rates appear closer to their “end point” than their starting point, default rates have barely begun their journey, while the most exposed areas may need re-calibration. 
  2. Certain areas of the asset class have seen a healthy dose of capitulation, and some even a very unhealthy dose (Chinese Real Estate Debt). Others, however, have moved in a purely systematic fashion and face the potential for further downside (as in point 1, we believe that the lowest-rated parts of the asset class are most exposed here). 
  3. Lending conditions as well as affordability are likely to put further pressure on borrowers. 4. New asset classes such as private credit have never truly been tested in the furnace of a credit cycle. There are likely to be winners and losers in these spaces. The fact that these segments of the market are yet to see material drawdowns should not be seen as a sign that they are immune to the financial conditions that have placed such stress on more liquid markets. Indeed, less liquid parts of Fixed Income markets almost always lag their liquid counterparts in periods of stress. 

We note with interest that both lending standards and affordability trends are likely to accelerate the upward trend in default rates and credit stress. 

Bank Lending Standards vs. HY Spreads and Default Rates

Bank Lending Standards:  tightening of rules during different recession waves in the US
Source: Federal Reserve, JPMorgan, Moody’s, National Bureau of Economic Research

US Housing Affordability Index

Housing Affordability Index:  mortgage loan qualification at national and regional levels based on most recent price and income
Source: National Association of Realtors. The Housing Affordability Index measures whether or not a typical family gets enough income to qualify for a mortgage loan on a typical home at national and regional levels based on the most recent price and income data.

All that Fixed Income has to offer in 2023

With all this in mind, I am delighted to be able to tell you that not only do I believe that Fixed Income will be an attractive investment in terms of return for risk in 2023 but that it will also see:

  • Material opportunities to deliver differentiated performance
  • Reward good quality risk management
  • Require ongoing vigilance, dynamism and discipline

All of the “bonus” characteristics mentioned above are long overdue for an asset class that has been predominantly driven by macro factors for large parts of the last decade. Those members of the Fixed Income community who have been conditioned like Pavlovian dogs to buy each dip have either been sent back to puppy school already or will be heading there at some stage over the next few years. The fun is certainly not over yet, folks!

To summarize, when it comes to our overall risk appetite within the asset class, we tend to deconstruct our view into the following: fundamentals, technical, value and tail risks. Our Risk Appetite (+2 from 0) has moved into positive territory off the back of the recent shifts that we have seen both in terms of Value (credit re-pricing) and the reduced possibility of further overshoot on inflation and rates. Although we will provide more details on this in future pieces, our current Risk Appetite view for the asset class as seen through this method is: 

Fixed income investment: investment strategy in the context of high inflation and recession fears

Economic outlook

(+1 notch)

Recession fears and stubbornly high inflation coupled with expected energy stress over winter continue to provide an uncertain economic backdrop, but mild weather has eased concerns based on the latter.

Credit Fundamentals

(-1 notch)

Generally, fundamentals have started to deteriorate and are expected to weaken going forward as reflected by worsening credit metrics in earnings reports.

Valuation & Technicals

(+1 notch)

Most credit markets have priced-in a recession, which makes valuations look even more attractive. While investor positioning remains light, outflows of fixed income have started to slow.

Tail risks

(+1 notch)

Risk of a Fed overshoot remains, but has been reduced by potential pivot. Immediate effect of energy crisis has recently been softened by mild weather.

What Fixed Income investors need to watch out for

Key take-aways within the underlying sub-assets classes and milestones to look for include:

  • Investment Grade credit is much better value than sub- Investment Grade. 
  • There will be overshoots on the journey towards a return to more “normal” levels. 
  • Looking at the pure Interest Rate element of yields, we believe that we are approaching terminal rates within market-implied rates curves. 
  • Pockets of underperformance will continue to persist where technicals are weak or where scar tissue exists; look for leverage or worse than expected liquidity conditions for clues as to where these may lie. 
  • Flows are likely to be “home biased” for some time given where yields sit on relatively boring subsets of the asset class, eliminating the need to “hunt for yield”. 
  • 2023 is likely to be a year in which Fixed Income receives a large uplift in asset allocations. 

In summary, we find ourselves against the backdrop of the market shifts seen last week, which are having an overall strongly bullish medium-term view on Fixed Income, but with significant bias towards simplicity and liquidity.

To the extent that these materials contain statements about the future, such statements are forward looking and are subject to a number of risks and uncertainties and are not a guarantee of future results/performance.