20 October 2022. This year has been challenging for fixed income investors, with a variety of indices posting their worst returns since records began. Recessionary fears have been escalated by persistent inflation and a strong labour market, which have pushed global central banks to continuously hike rates. Additionally, Europe’s energy crisis persists, putting heightened pressure on industrial and consumer prices.
The macroeconomic backdrop has impacted bond market volatility for the quarter. Though investors saw strong credit markets in July and the first half of August – reflecting a bear-market rally – this shifted completely in the second half of August and into September.
Darpan Harar, Co-Portfolio Manager, Multi-Asset Credit, Ninety One: “A blanket sell-off left active fixed income investors in vulnerable positions, and we believe that return dispersion between different credit asset classes will increase meaningfully.”
Relative to historical levels, investment-grade (IG) has underperformed high yield (HY), where credit spreads remain narrower than they were in 2018 and June 2022. The quarter saw a high degree of dislocation in the IG market, while floating rate coupon loans continued their streak of outperformance vs. most other asset classes. However, positive performance was very much skewed to July and August, with returns reversing in September as broader macroeconomic conditions deteriorated.
Following the categoric repricing of credit risk, almost all credit asset classes became attractively valued to varying degrees. However, when putting that value into context, analysis found that both higher quality and more liquid segments of the market appear the most attractive for investment, given recent market dislocation and the prevailing macroeconomic backdrop. Figure 1 demonstrates this further.
Figure 1. Cheapness of valuations vs. long-term averages - credit markets (Z scores)
Source: Bloomberg, ICE BofA, Citi Velocity, Ninety One, as at 30 September 2022. Charts plot Z scores (standard deviation from 10-year average credit spread) for different market segments, with a higher Z score indicating a cheaper valuation relative to the market segment’s history.
Tim Schwarz, Co-Portfolio Manager, Multi-Asset Credit, Ninety One: “If spreads rally tighter, quality assets are most likely to bounce, especially since quality segments appear to be oversold relative to lower-rated parts of the market. Given how quickly market valuations are evolving, we believe an unconstrained, dynamic approach is required to capitalise on not only the dislocations that currently exist within credit markets, but also the likely dispersion that will rear its head as the cycle matures.”