I wonder how many readers will have played the game Buckaroo?
For those that have not, it is essentially based around a plastic mule that is sensitive to pressure – the mule (called Roo) begins the game standing on all four feet. Players take turns placing various items onto the mule's back without causing the mule to buck up on its front legs, throwing off all the accumulated items. If he does it on your turn, you are out of the game.
It is a good analogy for markets at the moment. The bucking mule is recession, and the various items (interest rate hikes) are being strategically positioned by central banks to tackle the threat of inflation.
It comes to mind because, having seen bonds and equities pummelled in the first half of 2022, there are a few signs that things are starting to change – with global recession fears starting to replace inflation as the principal threat to markets.
For example, the commodities market implies recession fears are trumping inflation, with the price of numerous industrial materials – an indicator of activity – witnessing significant falls. Could recessionary Roo be about to buck?
Pain before gain
The path to higher interest rates is painful, but it should ultimately give bond investors opportunities in the longer term. That is welcome news for an asset class that has already seen some £6.6bn of outflows from retail investors in the first five months of the year.
In the first half of the year, the S&P 500 was down 20 per cent, while the broad US aggregate bond market was down 10 per cent. This is the first time bonds have not delivered positive returns when equities dropped by such a magnitude since the 1970s.
There will come a time when the final rate rise will come into view and all the bad news has been priced into the market. If recession comes, we will ultimately see rates stop rising (and eventually fall). And as soon as markets price that in, bond prices will rise. Timing that is almost impossible, so building a position now is worth considering.
Vincent Ropers, fund manager of TB Wise Multi-Asset Growth, says a good degree of downside news is already being priced in, meaning yields now offer a greater degree of protection, at around the 3 per cent level in US 10-year government bonds, 2 per cent in the UK, and 1 per cent in Europe.
He says with recession now looming large, bonds can act as a diversifier to equities – adding that with current bond yields offering a greater margin of safety, a compelling opportunity has arisen, meaning the team are subsequently allocating towards traditional bond strategies for the first time in years.
Active opportunities in investment grade and high yield
The challenge is timing these changes. In my opinion credit spreads will continue to widen, which will make investment grade and high yield start to look more compelling. But the rapid rise in interest rates from the US Federal Reserve will expose hidden leverage and cracks in the economy.
I think we are likely to see the first real credit cycle since 2008 with a subsequent rise in defaults – meaning active investing will matter.
Chris Bowie, manager of the TwentyFour Corporate Bond fund, says these opportunities are already starting to appear, adding that the aggressive re-pricing of fixed income over the past nine months has taken corporate bonds to their best yield level in years.
With recession looking an increasing likelihood, building a position in fixed income is beginning to look all the more attractive as a diversification option.He says this is particularly beneficial for higher-grade corporate bonds, adding that he favours financials in terms of fundamental quality given solvency and capital ratios are at all-time highs.
With the potential for rising defaults, the outlook for high yield is slightly murkier at this stage.
However, as Man GLG High Yield Opportunities manager Mike Scott points out: “While this downturn may bode poorly for high-yield returns at an index level, every downturn provides opportunity. In our view, investors should look to firms with pricing power to safeguard against inflation, while avoiding or shorting those firms most geared to the economic cycle.”
With recession looking an increasing likelihood – and pockets of value already emerging in the asset class – building a position in fixed income is beginning to look all the more attractive as a diversification option for both income and capital growth.
Funds to consider:
1. A strategic bond fund
Jupiter Strategic bond is a flexible ‘go anywhere’ offering, with decision driven by macroeconomic analysis of the world, with manager Ariel Bezalel happy to make significant changes to the portfolio and use derivatives to enable flexibility.
Not only is it one of the least volatile funds in the sector, it has also done an excellent job of preserving capital while still providing a high income and good, long-term performance.
2. A corporate bond fund
Managed by the experienced Stephen Snowden, the Artemis Corporate bond fund invests in investment-grade corporate bonds, with some ability to allocate across the wider fixed income market.
Snowden takes a long-term strategic and thematic view but will also take advantage of short-term opportunities when they present themselves. Over half the portfolio currently sits in BB-rated bonds with the largest sector exposure in banks.
3. A high-yield bond fund
Defaults may rise but an excellent stock-picker is worth their weight in gold.
Scott’s record as a stock-picker in the high-yield bond market is second to none – his fund currently yields 6.1 per cent, and has returned 22 per cent in the past three years.
Darius McDermott is managing director of Chelsea Financial Services & FundCalibre
