We have experienced the worst sell-off in corporate bonds that we have seen in their history, but it is an exciting time to be a bond manager, according to the co-manager of the Artemis Corporate Bond fund.
The conflict in Ukraine, leading to further issues with already-stretched supply chains, and a huge spike in energy prices and inflation has led to the worst performance seen in gilts, said Grace Le.
More unusually, there has been a similar rise in credit spreads.
“Indeed, this is the first time since at least 1999 that the index has derived a negative return from both gilts and credit spreads.”
Investment grade yields have readjusted meaningfully relative to other asset class yieldsGrace Le, ArtermisSo where does that leave us, she asked.
“[With] very attractive valuations.”
Historically, when investors are positive about the economy credit spreads reduce, as investors reduce their demands for extra yield to be paid as they have more confidence the company will be able to pay its debt.
In this environment, investors tend to sell off their risk-free assets (normally government bonds) to buy riskier assets.
“There is typically a negative correlation between how risk-free assets (government bond) and risky asset (credit spread or equity) behave, so it is very rare both would lead to negative returns at the same time,” Le said.
“All this said it is a genuinely an exciting time to be a bond manager,” she added.
“In short, we have waited many years for competitive income to return to our asset class.”
Although the repricing in fixed income markets is painful for investors, as years of quantitative easing is currently being unwound, the outcome of this means the current “starting point” is attractive, Le said.
“Investment grade yields have readjusted meaningfully relative to other asset class yields.
“We believe fixed income is setting up for compelling returns over the medium term and returns that will outstrip inflation over the coming years.”
How do valuations stack-up on a historical basis?
Yields look attractive and competitive compared to other income opportunities, Le said.
“In government bond markets, after being very cautious on valuations at the start of the year, we now see pockets of value emerging, by no means across the board but our focus most recently has been on shorter-dated bonds which already price in several BoE interest rate hikes.
Investors do not need to take on an aggressive amount of credit risk or very long duration positionsGrace Le, Artemis“We have also trimmed the fund’s underweight duration position as we are of the view that government bond yields are, once again, appealing enough to act as a hedge against risk-off environment.”
At the same time as yields are getting more attractive, Le said, investors are being asked to take less risk to earn this yield.
Because prices are now so low, investors can buy a bond below its redemption value, meaning they get very rare capital downside protection.
“We have to remember, the chance of investment grade companies defaulting is extremely remote, we’re talking about some of the largest and strongest companies in the world here,” Le said.
It is rare that the stars align to give investors this capital downside protection as well as a lower interest rate and capital risk.
“In summary, given the broad-based fixed income valuation reset – investors do not need to take on an aggressive amount of credit risk or very long duration positions in order to arrive at an attractive all-in-yield,” she added.
Going forward
“It is always dangerous to make predictions about the level of inflation or interest rates and base investment outcomes on being correct about those predictions,” Le said.
“But we believe inflation will remain elevated in the short-term and we believe it will take time for inflation to normalise to levels that we are all more accustomed to.”
It is unlikely for the Bank of England and Federal Reserve to hit their 2 per cent inflation target in 2023, Le said.
“What we can say with confidence is we are getting ever closer to the ‘zone’ for peak inflation across the UK.
“So, if we take today’s fixed income yields and compare them against the likely medium-term profile for inflation in the UK (as currently priced by the market), we believe bonds are setting up for compelling returns over the medium term and returns that will outstrip inflation over the years to come.”
sally.hickey@ft.com
