Three major global bond trends for H2
This is a challenging environment for bond investors as rising risk concerns come up against continued volatility in traditional safe-haven government bonds. The path of inflation and central banks’ desire to control it dominate the outlook for fixed income securities for the second half of 2022, including the Federal Reserve’s aggressive shift to tightening through rate hikes and inflation. a balance sheet reduction.
These and other central bank measures to slow their economies have contributed to lower fixed income asset classes amid fears of stagflation, which is understandable but, in our view, may be overstated given the levels of inflation. employment and strong consumer and business balance sheets, writes Steven Oh of Pinebridge Investment (pictured).
These challenges are exacerbated by major geopolitical risks, including the conflict in Ukraine and its implications not only for energy and food prices, but also for risk appetite across the credit spectrum. China’s shutdowns are also weighing on sentiment – although the Chinese government’s recent pivot to a “dynamic” Covid policy could bring back a sense of normalcy and help support its economy.
As we look ahead to the second half of the year, we see three key trends in the global fixed income sector of note: constructive on some segments of emerging market debt; high yield is catching up with loans; and a widening of short-term investment grade spreads.
Constructive on some segments of emerging market debt
We see value opportunities emerging in the context of sovereign and sector risk events coupled with strong core business fundamentals. Additionally, the lack of cash outflows following the events in Ukraine, the ongoing real estate malaise in China and limited supply contributed to the technical outlook.
Emerging market sovereign spreads tightened optically following the announcement in March that Russia and Belarus would be removed from the indices next month. Emerging market sovereign issuance is proceeding at just 40% of last year’s pace. Investment Grade significantly underperformed High Yield as market attention turned to the Fed’s hike cycle and the US Treasury curve reset.
But as assets have continued to exit the emerging market bond market, we see no signs of panic. We remain constructive over the long term given expectations of stable net issuance and continued new allocations to the asset class. We have historically favored corporate debt in emerging markets, which is relevant in a rising rate environment as the duration is much shorter than in the sovereign market.
High yield is catching up with lending
Leveraged financial markets have experienced some volatility, largely related to rate movements – particularly for high yield, as a fixed rate product. Treasury rates have widened significantly, which determines the trading position in loan and bond markets, and spreads on these assets have also widened.
High-yield bond and bank loan prices came under pressure as volatility soared and spreads widened rapidly amid growing concerns that Fed tightening could stifle growth and does not lead to recession.
Given the year-to-date movements in Treasury rates and the massive outperformance of loans relative to high yield, the weighted average price in the high yield market is significantly lower than in the loan market.
While we see the potential for high yield spreads to continue to widen and overshoot on the downside, we believe this gap in average discount to par will eventually provide a tailwind.
Investment grade spreads are expected to widen in the near term
In a largely technically driven market, the backdrop for Investment Grade credit is mixed. On the positive side, broker inventories remain relatively low. While an impending recession is not our baseline scenario, downside risks in this market necessitate continued defensive positioning.
As the longer-duration bond asset class, investment-grade credit has been hit hard by the Fed’s aggressive policy and bailout rates so far, with spreads widening significantly. Although purchases by Taiwanese insurers and US pension funds have offset some of the widening in spreads and overall yields remain attractive to investors, we believe spreads will continue to widen in the near term.
While continued defensive positioning could lead to a bit of a pullback in performance, we believe that with the Fed looking to tighten monetary conditions and shrink its balance sheet, the economy is strong but showing signs of weakness.
For this reason, rallies should be seen as an opportunity to further reduce risk and accumulate more dry powder in anticipation of a potential Fed pivot – in which case investors may want to be prepared to take risks. .
This article was written for the Portfolio Adviser by Steven Oh, Global Head of Credit and Fixed Income at Pinebridge Investments.