I know what you’re thinking, a fixed income manager says “buy bonds”. What a surprise. But actually, I think the opposite. I’m not saying “now is the time to buy bonds.” Well, not all bonds.
Now investors are facing a debt eradication. Government bonds are unlikely to give investors the yield they need in a time of high inflation. The best they can offer at the moment will still deliver a net loss in value in real terms. And at the other end of the spectrum in the high yield sector, risks of a global recession are likely to kick off a wave of bankruptcies and a potentially harmful default cycle.
A bumper borrowing spree
This is a marked departure from the investment environment of the last decade. Global high-yield bond issuance reached a record high of over $350bn in 2021, significantly above that seen in 2007 for example which was below $100bn. This bumper borrowing has been driven by a combination of the ultra-low interest rate environment, as well as quantitative easing (QE) which has pushed investors to consider bonds issued by riskier companies.
As central banks mopped up government bonds, there was arguably no alternative but to take advantage of the effect of all this cheap and abundant central bank money and move up the risk spectrum. While this was the aim of this round of monetary policy – to stimulate economies through additional investment. One of the major criticisms of a combined zero-interest rate policy and QE is that there were many, many ‘zombie’ high-yield companies kept alive.
Zombies are companies that earn just enough money to continue operating and service debt but are unable to pay off their debt. Such companies, given that they just scrape by meeting overheads (wages, rent, interest payments on debt, for example), have no excess capital to invest to spur growth.
There may be trouble ahead
As we move into an environment of quantitative tightening (QT) and much higher interest rates, high yield bonds will suffer, as these highly levered companies won’t be able afford higher interest payments on their debt and in many cases will simply run out of cash before they get to the point at which their bonds need refinancing.
Sensibly, high yield companies have been able to term out their debt to a degree. But in a much higher interest rate environment and tightening economies, this is only delaying the inevitable. The market has worked this out and this is why there have only been a handful of high-yield issuances since February and the high-yield market has become increasingly illiquid as a result.
And, as the reality of recession sinks in, it is more likely that these companies will simply run out of money before they get a chance to refinance. Real estate, retail, consumer goods are good examples of the type of sectors that are likely to experience most pain as stagflation persists. Stagflation of course, is a period when slow economic growth coincides with rising inflation.
In the UK, the rise in the living wage will further dent company balance sheets as well as leading to more persistent inflation. We don’t expect ‘zombie’ companies to rise now that zero interest rate policy is gone and QT is upon us.
An investment silver lining?
Whilst we still don’t think government bonds, particularly long-dated, are a good investment and high-yield is clearly fraught with danger, there is one part of the fixed income market where the opportunity cost of not being invested is far too great in our view.
The key to potential stable returns through fixed income assets in this market is the compound interest gained through buying the debt of ‘low risk’ companies able to provide high single-digit yields. These investment grade companies historically have a very low default rate and should be the most resilient as recession risk grows due to their significant free cash flow. Opting for short-dated bonds also reduces price risk from the government bond market.
Investment grade bonds are now trading at high single digit yields, offering significantly higher returns than government bonds, and looking comparatively more attractive as a result.
Certain sectors within investment grade stand out
With an incoming rise in the minimum wage, and a red-hot labour market in the UK and Europe as well as the US, many companies are going to face difficult cost pressures. With this in mind, we see opportunity in financials and utilities.
The financial services sector has been through its own crisis and undergone more than a decade of reconstruction since 2008. Banks are smaller and regulation has made for stronger balance sheets. Put this together with rapid margin expansion due to interest rate rises and the sector stands out as one that will do relatively well in this new world. Life insurance companies too look excellent due to the value of their liabilities dropping as interest rates rise, boosting solvency levels.
While the macroeconomic picture remains challenging, and we believe the debt eradication phase is here to stay for the near term, opportunities for strong returns can still be found in selected corners of the fixed income market. As the recession thunder builds and inflation persists, short-dated investment grade bonds look increasingly like they could be the safest port in the storm.