The return of bonds
Where are the best opportunities as fixed income moves towards a new paradigm?
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High-quality short dated investment grade credit is increasingly being favoured by investors of all types - from individuals to investment professionals - for a variety of reasons
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Fixed income returns to prominence
Income opportunities: The case for bonds now
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FIDELITY
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Fixed income opportunities: Evaluating spreads vs. yields
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Important information For Professional Clients only and not to be distributed to or relied upon by retail clients. Past performance is not a guide to future performance. Opinions and examples represent our understanding of markets: they are not investment recommendations advice. All data is sourced to Aegon Asset Management UK plc unless otherwise stated. The document is accurate at the time of writing but is subject to change without notice. Data attributed to a third party is proprietary to that third party and is used by Aegon Asset Management under licence. Aegon Asset Management UK plc is authorised and regulated by the Financial Conduct Authority. Adtrax 6105984.1; Expiry 30 April 2025
Income opportunities: the case for bonds now
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Even if spreads or yields widen from here, the breakeven rate for bonds is now considerably more attractive. The breakeven rate measures how high yields (or spreads) would need to rise before the total return of a bond becomes negative, typically over a one year time horizon. The total return of a bond has two components: price return and income return from coupon payments. Prior to 2022, there was little income or yield available from newly issued bonds as markets had a prolonged period of low interest rates. However, as rates have shifted higher, yields across fixed income have risen and newly issued debt now offers higher coupon rates. Therefore, bond prices can now fall by a much greater degree before the total return becomes negative. For example, the yield on the US High Yield Bond Index can rise from the current level of 7.9% to over 10% - through wider spreads and/or higher core yields - before total returns break even. For US investment grade, yields can widen by 100 bps before investors lose money. This cushion is the biggest it has been for over a decade.
While there are attractive opportunities for fixed income investors to take advantage of current yields, we are cognisant that risks remain. While not our base case, reacceleration in inflation or a deeper-than-expected recession, could impact future returns. Therefore, an active management approach is necessary to navigate fixed income markets.
Enhanced breakeven rates
Corporate bond spreads have narrowed to lows not seen since 2022. As the cycle extends and economy slows, it is no wonder investors are starting to worry about potential spread widening given the upside for capital returns is now more limited. However, the attractiveness of asset classes can be evaluated using various metrics including yields, spreads, expected returns, etc. Many fixed income assets offer higher yields than has been normal in the last decade. Fixed income also offers enhanced income as coupon rates have reset higher. While spread levels look less compelling, all-in yields and higher coupons remain attractive.
Spreads have narrowed, but yields remain attractive
Rising rates have led to attractive yields across the fixed income market. However, corporate credit spreads are tight. This leaves many investors grappling with the valuations conundrum, as they debate yields versus spreads to determine their fixed income allocations. Will slowing economic conditions result in spread widening? Do higher yields provide a sufficient cushion against downside risk? And is now the time to add fixed income exposure? In our view, it’s not too late for fixed income investors to take advantage of elevated yields.
Although spreads are tight, investors mustn’t lose sight of the bigger picture. Over the long term, the starting yield has been a steady indicator of future long-term total returns. As shown below, the starting yield-to-worst for the high yield index has been close to the subsequent annualised five-year return. This relationship has generally held true in strong and weak economic environments, as well as periods with tight and wide spreads, With high yield corporate bonds offering a starting yield to worst around 7.7%, we continue to like the asset class on a yield basis.
Past performance doesn’t predict future returns, but can yields?
Enhanced breakeven profile for corporate bonds
Source: Aegon Asset Management, Bloomberg as at 31 December 2023. Based on the ICE BofA Global High Yield Index. Past performance is not a guide to future performance.
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US High Yield index - YTM (%)
Breakeven calculator
Yield rises > 300bps to 11% for negative total return
Yield unchanged = 7.9% return
Yield falls 100bps to 6.9% = 11% return
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Yield rises > 100 for negative total return
Yield flat = 5.5% return
Yield falls 100bs for >13% return
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Yield to Worst
5 Year Forward Annualised Return (%)
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Starting yields have been a reasonable estimate 5 year returns
ICE BofA Global High Yield Index monthly YTW and forward 5 year index returns
8.8
9.1
6.1
6.0
8.4
Dec 2009 Post-GFC rally
Dec 2012 Prior to Taper Tantrum
Jan 2016 Energy crisis
20.8
22.0
7.4
7.3
12.9
13.8
Oct 2002 Tech bubble
May 2007 Pre-GFC tight spreads
Nov 2008 GFC wide spreads
Mark Benbow, portfolio manager
Thomas Hanson, head of Europe high yield
Colin Finlayson, portfolio manager
Alex Pelteshki, portfolio manager
CONTRIBUTORS
Why it’s not too late for fixed income investors to take advantage of elevated yields
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Fixed Income opportunities: evaluating spreads vs. yields
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Climate Transition: Avoid? Invest? Engage?
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“For income-oriented investors, now is the time to consider bonds”
Income is primary driver of returns in the high yield market
Source: Bloomberg, ICE BofA. As of 31 December 2023. Reflects the cumulative price and income return for the ICE BofA Global High Yield Constrained (HW0C) index. Past performance is not a guide to future performance.
Enhanced yields across fixed income
Current and historical index yields last 10 years
Yield to worst (%)
6.76
4.74
4.85
2.42
3.10
0.61
EM HC Aggregate
US Aggregate
Euro Aggregate
Global Aggregate
Global Treasuries
Global Corporates
Global High Yield
3.74
1.64
3.16
1.09
4.88
2.61
8.09
6.22
10 year range
Current
10 year median
Source: Aegon AM, Bloomberg. As at 31 March 2024. Based on Bloomberg indices. Past performance is not a guide to future performance.
As rates have shifted higher, bond coupons have increased. Investors no longer need to increase their risk exposure through lower-quality credit to access attractive coupon rates. Instead, we are uncovering high income opportunities across the ratings spectrum. BBB and BB bonds now provide a sweet spot for investors from a risk/return perspective. Companies in this space can still afford to pay higher coupon rates, but are also better set up to weather a potential economic slowdown. For high yield investors, higher-quality BB bonds now offer double-digit coupons; a safer option compared to lower-quality CCC debt. In our view, this is an opportune time to lock in high coupons in higher-quality bonds and add steady income.
Opportunities now: Locking in high income in higher-quality bonds
Higher rates provide relatively rare opportunities to pursue enhanced yields and high income across fixed income markets. However, lingering macro risks and slowing economic conditions present headwinds. Corporate fundamentals are showing signs of deterioration amid elevated rates and slowing economic growth. That said, many companies are starting from a position of strength and are well-positioned to navigate a slowdown, which should help keep defaults contained. Tight spreads are also causing some investors to pause. While it is right to be cautious, it is important to see the bigger picture. It can be tempting to try time the market and wait for wider spreads to present entry points. Tactical opportunities may arise, but as the saying goes, it is time in the market, not timing the market that matters. While spreads could widen, don’t underestimate the power of carry as income drives fixed income returns over the long term, particularly at these yields. For income-oriented investors, now is the time to consider bonds.
Balancing risks and opportunities in fixed income
The total return for bonds consists of income (coupons) and price (capital) returns. Although price movements are a component, income has been the largest driver of fixed income total returns over the long term. This steady income, or carry, from coupons can provide a buffer against price movements. While prices can be volatile, income provides a steady constant over time. As shown below, the global high yield index has delivered steady income over the years, despite price volatility. Higher coupon rates today means bond markets can provide income that investors are currently demanding from money markets, even when cash rates decline.
Carry on: Income drives returns in fixed income
As central banks have begun or are expected to start cutting rates, we are reminded that elevated cash rates won’t last forever. While cash and money market funds provided steady income in recent years, continuing to hold cash will eventually prove to be costly as money market rates reset lower and do not benefit from price appreciation when rates decline. We believe it is time to consider re-allocating from cash to fixed income. Various segments of the market currently offer yields at multi-year highs (see below), which provide investors an attractive alternative to cash in the cutting cycle ahead.
Turning point: High cash rates will fade, look to bonds for elevated yields
Bonds are back with opportunities across the fixed income market. Although cash and money market funds have delivered steady income in recent years, we believe that now is the time to seize opportunities in the bond market to add income and pursue enhanced total returns.
Why now is the time to seize opportunities in the bond market to add income and pursue enhanced total returns
Important information For Professional Clients only and not to be distributed to or relied upon by retail clients. Past performance is not a guide to future performance. Opinions and examples represent our understanding of markets: they are not investment recommendations advice. All data is sourced to Aegon Asset Management UK plc unless otherwise stated. The document is accurate at the time of writing but is subject to change without notice. Data attributed to a third party is proprietary to that third party and is used by Aegon Asset Management under licence. Aegon Asset Management UK plc is authorised and regulated by the Financial Conduct Authority. Adtrax 6105984.2; Expiry 30 April 2025
Fixed Income opportunities: Evaluating spreads vs. yields
Risk warnings Market volatility risk: The value of the fund and any income from it can fall or rise because of movements in stockmarkets, currencies and interest rates, each of which can move irrationally and be affected unpredictably by diverse factors, including political and economic events. Bond liquidity risk: The fund holds bonds which could prove difficult to sell. As a result, the fund may have to lower the selling price, sell other investments or forego more appealing investment opportunities. Derivatives risk: The fund may invest in derivatives with the aim of profiting from falling (‘shorting’) as well as rising prices. Should the asset’s value vary in an unexpected way, the fund value will reduce. Credit risk: Investments in bonds are affected by interest rates, inflation and credit ratings. It is possible that bond issuers will not pay interest or return the capital. All of these events can reduce the value of bonds held by the fund. Higher-yielding bonds risk: The fund may invest in higher-yielding bonds, which may increase the risk to capital. Investing in these types of assets (which are also known as sub-investment grade bonds) can produce a higher yield but also brings an increased risk of default, which would affect the capital value of the fund. Charges from capital risk: Where charges are taken wholly or partly out of a fund's capital, distributable income may be increased at the expense of capital, which may constrain or erode capital growth. Emerging markets risk: Compared to more established economies, investments in emerging markets may be subject to greater volatility due to differences in generally accepted accounting principles, less governed standards or from economic or political instability. Under certain market conditions assets may be difficult to sell. Currency hedging risk: The fund hedges with the aim of protecting against unwanted changes in foreign exchange rates. The fund is still subject to market risks, may not be completely protected from all currency fluctuations and may not be fully hedged at all times. The transaction costs of hedging may also negatively impact the fund’s returns. ESG risk: The fund may select, sell or exclude investments based on ESG criteria; this may lead to the fund underperforming the broader market or other funds that do not apply ESG criteria. If sold based on ESG criteria rather than solely on financial considerations, the price obtained might be lower than that which could have been obtained had the sale not been required. Income risk: The payment of income and its level is not guaranteed. Please refer to the fund’s prospectus for full details of these and other risks, including sustainability risks, which are applicable to this fund.
Important information FOR PROFESSIONAL INVESTORS AND/OR QUALIFIED INVESTORS AND/OR FINANCIAL INTERMEDIARIES ONLY. NOT FOR USE WITH OR BY PRIVATE INVESTORS. This is a marketing communication. Before making any final investment decisions, and to understand the investment risks involved, refer to the fund prospectus, available in English, and KIID/KID, available in English and in your local language depending on local country registration, from www.artemisfunds.com or www.fundinfo.com. CAPITAL AT RISK. All financial investments involve taking risk and the value of your investment may go down as well as up. This means your investment is not guaranteed and you may not get back as much as you put in. Any income from the investment is also likely to vary and cannot be guaranteed. Investment in a fund concerns the acquisition of units/shares in the fund and not in the underlying assets of the fund. Reference to specific shares or companies should not be taken as advice or a recommendation to invest in them. For information on sustainability-related aspects of a fund, visit www.artemisfunds.com. The fund is a sub-fund of Artemis Funds (Lux). For further information, visit www.artemisfunds.com/sicav. For changes made to the Artemis Funds (Lux) range of Luxembourg-registered funds since launch, visit www.artemisfunds.com/historic-changes. Third parties (including FTSE and Morningstar) whose data may be included in this document do not accept any liability for errors or omissions. For information, visit www.artemisfunds.com/third-party-data. Any research and analysis in this communication has been obtained by Artemis for its own use. Although this communication is based on sources of information that Artemis believes to be reliable, no guarantee is given as to its accuracy or completeness. Any forward-looking statements are based on Artemis’ current expectations and projections and are subject to change without notice. Issued by: Artemis Investment Management LLP which is authorised and regulated by the UK Financial Conduct Authority
Sources 1, 2. BofAML/Bloomberg 3. Company reports, Bloomberg as at 29 December 2023. The index is the ICE BofA Merrill Lynch Global High Yield Constrained Index 4. BofAML 5. ICE BofA US High Yield Index as at 31 December 2023 6. Bloomberg as at 31 January 2021 7. Bloomberg, Artemis as at 31 December 2023 8. As at 01/04/2024 9, 10, 11. ICE BofA indices as at 31 December 20233:.
Learn more about Artemis
For investors who saw the title of this article and assumed it referred to a high-yield bear market, the good news is that improving economic conditions and the prospect of falling interest rates make this unlikely. In addition, when yields from this asset class have been this high in the past (the ICE BofA US High Yield Index Yield to Worst is currently at 7.5%) , you have had an almost 80% chance of making money over a one-year period if taking a long position . Over three years, this rises to almost 90% . And in 90% of those periods in which you ended up in positive territory over three years, you would have made 3.5x as much as you lost in the periods when you ended up out of pocket . Simply being invested in this asset class at this point should be enough to make a decent risk-adjusted return over the medium term. But if an opportunity to add value comes “strutting, gesticulating and moonwalking” into the high-yield market – well, we think we know where to find it.
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Jack Holmes is the manager of the Artemis Funds (Lux) – Global High Yield Bond fund, an actively managed fund that aims to increase the value of shareholders’ investments through a combination of income and capital growth.
The moonwalking bear market
Moving away from the largest issuers is not the only way to obtain an advantage when it comes to high yield. Taking a genuine global approach can deliver a similar impact. About 90% of the assets in high-yield funds are in those that focus on a particular region (mainly the US) . While most of the rest of the money is in funds that claim to be global, I would argue that in many cases these are just two regional funds that have been stuck together and rebranded, managed with little if any reference to one other. Running funds in this way means overlooking a quirk whereby an international company can issue two bonds from the same part of the capital structure and with the same maturity, but that offer different yields depending upon which country they are issued in. Taking advantage of this mispricing doesn’t involve taking a complex macro view on the direction of currencies – we simply hedge this risk. But even after this cost is incurred, it has been possible to earn up to 3 percentage points more over the past two years by lending to certain companies in euros rather than dollars (and vice versa) . As the graph below shows, this relationship isn’t consistent and the prices of the euro/dollar bonds move around a lot. But the small size of our fund and relative freedom compared with more benchmark-driven approaches let us flip between the two whenever relative valuations suit. It also highlights that simple top-down allocation between different currencies won’t capture these opportunities – these only come about through bottom-up analysis.
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Geographical opportunities
The vast majority of high yield AuM is in funds with a regional approach
Which leads to inefficient pricing opportunities for truly global investors
Source: Bloomberg as at 31 January 2021.
Source: Bloomberg, Artemis as at 31 December 2023. Note: reference to specific stocks should not be taken as advice or a recommendation to invest in them.
Smaller issuers have tended to outperform over longer time periods, and with lower drawdowns
Source: ICE BofA US High Yield Index as at 31 December 2023. Note: small = bottom quartile of total face value issuer sizes; medium = 2nd and 3rd quartile of total face value issuer sizes; large = top quartile of total face value issuer sizes
It is important to remember that ‘smaller issuers’ does not mean ‘smaller companies’. Some have earnings in the billions, and market caps in the tens of billions, yet they are classed as smaller issuers for the simple reason that high yield does not account for a significant proportion of their capital stack.
Less analyst coverage makes it easier to gain an informational advantage away from the largest issuers. But the data shows medium- and smaller-sized issuers have delivered higher returns than their larger counterparts since the inception of the global high-yield universe in 1997 . In this way, it is similar to the small-cap effect in equities over the long term. But that is about as far as the comparisons go. Whereas with equities, higher-longer term returns from smaller companies come at the expense of higher volatility, the opposite is true in high-yield bonds. In the years of the biggest losses for this market – after the bursting of the dotcom bubble, the Global Financial Crisis and Covid – small issuers lost less than medium and larger ones .
Informational advantage
Our view is that while the extreme value available in some areas of the high-yield bond market may not quite be “strutting, gesticulating and moonwalking” in front of investors, it is obvious to those whose attention isn’t focused elsewhere. The global high-yield market is made up of about 1,500 companies which have collectively issued debt worth more than $2trn . Yet of those 1,500 companies, just 200 account for about half the index by weight .
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Most high-yield funds will focus on this area of the market, either because of their large size or because they are index-led. In contrast, running high-conviction funds allows us to focus on what we call ‘the undiscovered tail’. I recently heard about a major asset manager running a number of large high-yield funds that won’t allow research resources to be put into issuers that are less than 10bps of the index. This means they wouldn’t even look at many of our holdings, such as auctioneer Sotheby’s and miner Perenti. At 3bps and 2bps of the index respectively, it would be polite to refer to these companies as a rounding error. In fact, they are not even that.
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Standout value
Artemis global high yield focuses on the wider market - exploiting the under-covered and inefficiently priced ‘tail’
100 largest issuers in index account for 36% of total index weight and are focus of most index-oriented high yield investors; however only c.10% of Artemis Funds (Lux) Global High Yield Bond
Remainder of fund is non-HY: Non-rated corporates 2.9%: Investment grade: 5.6% Non-index HY (AT1 and WBS): 5.2%
Source: BofAML, Bloomberg, Artemis as at 31 December 2023.
A minute-long video clip called ‘Awareness Test’ went viral in 2008, racking up more than 10 million views, due to an editorial sleight of hand that challenged viewers to test their attention to detail, only to pull the rug from under their feet. Inviting the viewer to count how many passes were made by a basketball team, the video showed about 20 seconds of a practice session before revealing the answer – 13. But it is here where things took a turn for the surreal, when it asked: “Did you see the moonwalking bear?” The reason for this seemingly bizarre question was that while the viewers focused on counting the number of passes, most were completely oblivious to a man dressed in an amateur-looking bear costume strutting, gesticulating and moonwalking through the middle of the very basketball session they were supposed to be concentrating on. The message of the video – released on behalf of Transport for London to promote awareness of cyclists among road users – was a simple one: “It’s easy to miss something you’re not looking for”. So, what does this have to do with high-yield bonds?
Jack Holmes, fund manager
AUTHOR
Smaller issuers in the high-yield market have traditionally returned more than their larger peers and lost less during times of crisis. So why don’t more funds hold them?
Source: ICE BofA US High Yield Index as at 31 December 2023. Note: small = bottom quartile of total face value issuer sizes; medium = 2nd and 3rd quartile of total face value issuer sizes; large = top quartile of total face value issuer sizes.
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Important information This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates rise and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Due to the greater possibility of default, an investment in a corporate bond is generally less secure than an investment in government bonds. Fidelity’s range of fixed income funds can use financial derivative instruments for investment purposes, which may expose them to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Reference to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes. Investments should be made on the basis of the current prospectus, which is available along with the Key Investor Information Document (Key Information Document for Investment Trusts), current annual and semi-annual reports free of charge on request by calling 0800 368 1732. Issued by FIL Pensions Management, authorised and regulated by the Financial Conduct Authority. Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM0424/386634/SSO/NA
Describing his fund as a “core, bog standard, boring corporate bond fund that just happens to be doing quite well”, Snowden is positioned for this further rally in credit spreads. This is most evident in the Duration Times Spread ratio on the portfolio. This is currently 1.3x on the fund and measures credit volatility, comparable to equity beta. Though bullish, Snowden is wary about the presence of persistently high wage inflation. This is something he sees as the biggest risk facing bond investors over the next year. “The economy continues to do much better than people think, that allows more confidence in wage negotiations despite inflation still coming down,” said Snowden. “There is still that wage bargaining power and to my mind that is the largest risk. “We’re not pricing in excessive base rate cuts, so if wage inflation continues to be higher than we think then you’re not looking at a material selloff in bonds – you just won’t get that capital appreciation.”
A challenging lending environment for UK corporates poses a potential boost for bond fund managers, with Artemis head of fixed income Stephen Snowden positioning his strategy to benefit from this ‘acute pain trade’. In a recent webinar, Snowden explained how many corporates had become accustomed to a low interest rate environment and the benefits this afforded their debt structures. This had allowed finance directors to ‘term out’ their debt, changing the classification of debt on their balance sheets to improve working capital and take advantage of lower interest rates. Snowden, who manages the £1.4bn Artemis Corporate Bond Fund, explained how the situation had since changed to benefit fund managers like him. As well as greater inflows, with fixed income gaining more attention due to higher yields, this has seen him able to capitalise on corporates’ disadvantaged position.
“At the very same time as yields are attractive to us to buy, they are unattractive to the companies to give us those bonds to buy,” said Snowden. “You have an acute pain trade where if you’ve not set up your fund for a rally, you get money coming into your fund but very few opportunities in new issues to reinvest money. That has led to a very acute rally in credit spreads.” Therefore, Snowden expects the demand for bonds to remain high while supply is low. The context that supports this demand is corporate bonds are still out-yielding equities (when comparing the ICE BofA £ Corporate & Collateralised Index with the FTSE All-Share Dividend Index). This has seen Snowden position his fund to benefit from the “classic” pain trade. He expects credit spreads, despite already rallying, to continue to do so: “We have further to go – [this is supported] by a blend of the fundamental and technical backdrops. Low supply of corporate bonds, combined with high demand, will drive credit spreads tighter. “I know it's not the consensus thing to say, but that is what is happening and that is what is going to happen going forward.”
“We’re not pricing in excessive base rate cuts, so if wage inflation continues to be higher than we think then you’re not looking at a material selloff in bonds”
Stephen Snowden, fund manager
“Low supply of corporate bonds, combined with high demand, will drive credit spreads tighter”
CONTRIBUTOR
Restricted supplies of new bonds from companies reluctant to borrow at today’s higher rates coupled with high demand from investors are creating a powerful technical backdrop for the corporate bond market
View our webinar
Important information This information is for investment professionals only and should not be relied upon by private investors. The value of investments and the income from them can go down as well as up so you may get back less than you invest. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates rise and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Due to the greater possibility of default, an investment in a corporate bond is generally less secure than an investment in government bonds. Fidelity’s range of fixed income funds can use financial derivative instruments for investment purposes, which may expose them to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Reference to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes. Investments should be made on the basis of the current prospectus, which is available along with the Key Investor Information Document (Key Information Document for Investment Trusts), current annual and semi-annual reports free of charge on request by calling 0800 368 1732. Issued by FIL Pensions Management, authorised and regulated by the Financial Conduct Authority. Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM0424/386634/SSO/NA
Learn about the Fidelity Short Dated Corporate Bond Fund
Like its peers, the Fidelity Short Dated Corporate Bond Fund has a low rate of turnover but it is more active than most. The team on the fund are prepared to act strategically and the managers are excited about the opportunities an upcoming period of rate cuts could present. Atkinson and Gohil’s analysts are already researching strategic trade opportunities in the front end of the yield curve in anticipation of a potential market dislocation. This is due to what Atkinson says is the likelihood of “ridiculous valuations” within fixed income as markets attempt to react accordingly to rate cuts. “One of the things that we really relish is actually periods of market dislocation because often that's where you see bonds coming out and they will be trading at ridiculous valuations,” says Atkinson. “The reason is because when you see volatility in the markets, you see outflows. With people having to raise cash, the first thing they often sell is their short-dated bonds because the capital impact is smaller for them by selling these.” This strategy has served the team well. In previous rate cutting periods where short-dated debt has outperformed cash, Atkinson says the fund has been able to gain performance simply from taking advantage of bondholders being forced to sell. “We have the firepower to take advantage of that and the credit team who have already done the homework and know the names,” says Atkinson. “If a broker comes to us and says someone has just hit me with £10m of XYZ and I can't warehouse this risk, can you take them? In that instance we can say yes but this is our price. And that is just a culmination of all those factors that we mentioned, the credit team, the trading desk, having access to the markets and doing the nuts and bolts of your credit [analysis].”
Taking advantage of market dislocation
This has led markets to price in a number of rate cuts this year. Should rates fall, the same will happen with the yield on cash and leave holders exposed to reinvestment risk. In this environment, yield curves may steepen and present new fixed income opportunities, particularly among short-dated bonds at the front end. This is where the managers of the £496m Fidelity Short Dated Corporate Bond Fund, Kris Atkinson and Shamil Gohil, are anticipating the best opportunities. “By having short-dated bonds you get the benefit of that inverted yield curve but you also get a little bit of duration,” explains Atkinson. “That duration is really important when you start to see rates dropping because obviously all bonds have some degree of reinvestment risk; it just depends on how short maturity you are. When rates start to fall, that will give you some capital appreciation at the front end of the curve, and offset any spread widening that you may or may not see in credit.” There is precedent for this. The managers point to the last four most recent rate cutting cycles, where in each situation short-dated credit outperformed cash. While credit risk does increase in these periods, Gohil reasons that holding good quality debt with a short duration – often to maturity – provides enough compensation and liquidity. “Effectively, we're harvesting both the excess credit premium and the liquidity premium, we get some duration and we don't have much reinvestment risk,” says Gohil. “Based on a very modest cutting cycle, you can generate decent total returns in an environment where equities are probably going to be recording single or double digit drawdowns.”
Caught out by falling rates
After over a decade of near zero interest rates, the return of inflation forced central banks around the world to raise these. One of the asset classes that benefited most during this period was cash which began to offer above nominal yields once again, naturally prompting some investors to increase their allocations. However, with inflation falling to nearer target levels, the consensus is that central banks will be more likely to cut rates in 2024 than sustain them. In the UK, although inflation has still not reached the Bank of England’s 2% target, stagnating growth and a technical recession are putting pressure on the Monetary Policy Committee to act.
“One of the things that we really relish is actually periods of market dislocation because often that's where you see bonds coming out and they will be trading at ridiculous valuation”
Shamil Gohil, fund manager
“By having short-dated bonds you get the benefit of that inverted yield curve but you also get a little bit of duration”
Kris Atkinson, fund manager
With holders of cash potentially about to be caught out by cuts in interest rates, why does short-dated fixed income offer a natural home for this capital?
OTHER ARTICLES FROM FIDELITY
Conversely, Atkinson and Gohil are limiting their exposure to sectors that may be more vulnerable to recession in 2024. This includes commodity-focused names and sectors exposed to consumer behaviour. Banks and real estate are included in this by the managers, but there are still seeing opportunities within these, despite their vulnerability to economic volatility. The managers benefit from a deep analyst bench and are able to be selective, separating strong names from the weak within both sectors. “Where we do have exposure in banks, and you have to own some as it's a big part of our universe, we tend to focus on the big, solid banks,” says Atkinson, making a clear demarcation from smaller banks with less capital or more concentrated loan books. “Where we do have bank exposure it's high quality again because it's not much to give up in owning that and you own much more liquid parts of the market there.” Likewise, within real estate Atkinson and Gohil have been discerning and opted for the defensive areas of the sector – with residential and logistics being two key examples – instead of office and retail sites. “Again, it's issuer selection,” adds Gohil. “A lot of these companies have been oversold, are cheap and are doing the right thing. As a broad brush, that sector has just been unloved for a while. We are starting to see that reverse now, which has benefited our performance.”
Issuer-specific opportunities
The high cost of debt refinancing is hitting some companies hard, especially within the SME space where insolvencies have increased. This has highlighted the importance of quality, with Atkinson and Gohil preferring to hold investment grade names against this backdrop. The managers have focused on defensive sectors and particularly those backed by physical assets, such as property or utilities, that can underpin valuations. The pair have made these moves mindful of upcoming volatility from monetary policy in the UK. Though not bearish, Gohil points to a potential “policy error” from high rates being sustained for too long and the potential repercussions of this. “UK growth is stagnating, and we don’t really have much headroom there in terms of holding rates for much longer,” says Gohil, who explains they are targeting high quality companies that are better placed to “weather that storm”. Within investment grade, this has included regulated utilities like water which offers inflation protection qualities despite current negative publicity. “Given all the headlines we've seen in the press around the water sector, that is having a knock-on impact in the markets and creating a sector which is recession proof, inflation proof, highly regulated and pretty cheap,” explains Gohil. “We accept that we're going to have to hold our noses and tolerate some daily headlines from various parts of the media but that's something that we think is particularly attractive.”
Preparing for the storm
Despite becoming more expensive, investment grade debt could present opportunities for fixed income investors against a backdrop of higher rates. With higher rates, many investors have gravitated towards high yield debt and shunned investment grade names. However, companies in the latter category have been able to benefit and generate higher revenues during this period. Many of these companies were also able to raise finance with tight coupons during the years of quantitative easing, leaving them with surplus liquidity. And unlike high yield companies, these corporates have been able to earn more on their cash balances. This is why the managers of the £496m Fidelity Short Dated Corporate Bond Fund, Kris Atkinson and Shamil Gohil, are seeing the best opportunities in investment grade debt. Atkinson points to the example of two differently rated issuers in the same industry. “Imagine you had a supermarket that was a B-rated issuer - most of its debt historically has been around the 4% mark and they refinanced at 10%ish,” says Atkinson. “You very quickly can see how their cost of funding spiked. “Then you look at investment grade competing supermarket. Their cost of funding has gone up by a similar order of magnitude, but from a couple of percent to probably 5% or 6%. And that's on 7% of their debt stack. It will take a lot longer for them to feel the impact of higher rates.”
“It’s issuer selection. A lot of these companies have been oversold, are cheap and are doing the right thing”
“Given all the headlines we've seen in the press around the water sector, that is having a knock-on impact in the markets and creating a sector which is recession proof, inflation proof, highly regulated and pretty cheap”
With rate cuts looking increasingly likely, could fixed income investors benefit from holding higher rated debt?
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Strike the right balance with bonds at PGIMFunds.com
Investor sentiment appears to suggest otherwise, but a recession is still a distinct possibility for the world’s largest economy. Perhaps investors envision a scenario that, although slightly less likely, remains plausible, such as an exceptionally uneventful soft landing. According to Gregory Peters, co-chief investment officer at PGIM Fixed Income, the highest-probability outcome is somewhere in between, which he considers to be good news for bond investors. Key features in this model macro scenario include inflation that runs above target without being disruptive and below-trend growth that still fosters an environment with room for spending on technology, research and manufacturing capacity to expand. Moreover, at current levels, yields offer bond investors a level of protection not seen in years. In the accompanying video, Peters explains how these conditions should shape the monetary policy picture and why, when he assesses the 2024 market backdrop, he sees ‘a great opportunity for fixed income.’
Gregory Peters, co-chief investment officer, PGIM Fixed Income
Inflation that runs above target without being disruptive and below-trend growth that leaves room for corporate spending could offer a great opportunity for fixed income
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As a leading active global asset manager, PGIM Fixed Income can help investors navigate and analyse complex bond markets. Local expertise combined with deep credit research resources across bond sectors and regions help uncover value and deliver long-term returns. ‘We are a bottom-up manager with deep credit management expertise,’ Peters said, ‘and we’re finding many great opportunities in today’s fixed income environment.’
Analysing opportunities with an active fixed income leader
High yield bonds sit high on this list. Many fixed income investors remained on the sidelines in this sector in recent years, expecting a recession in 2023 that never arrived. This led to underweight high yield allocations in their portfolios, a situation that Peters said is changing. ‘Global high yield is seeing some inflows as investors realise that the risk of recession is coming down meaningfully,’ Peters said. Most forecasts expect new high yield bond issuance between $170 billion and $230 billion (USD) in 2024, which Peters views as manageable considering the $1.35 trillion size of the market. Investors can find dispersion opportunities these days in both B-rated and CCC-rated bonds, he said. With recession fears fading, Peters sees defaults in the high yield sector remaining contained at 3.5% over the next 12 months. He noted that many issuers have de-levered their balance sheets and are waiting to refinance their debt, creating a full pipeline of potential improvements to investment-grade ratings. ‘We see areas of value in high yield,’ Peters said. ‘It’s a very different picture versus 10 years ago.’
Pivoting toward high yield
In addition to high yield bonds, PGIM Fixed Income is finding value in securitised credit, particularly at the top of the capital structure, as well as in select investment-grade corporate bond sectors such as banks and pipelines. Peters cautioned investors to be careful and tactical about duration and curve risk because the yield curve remains inverted. While many investors have parked significant assets in cash in recent years to benefit from higher yields, Peters noted that cash yields will likely fall when central banks cut interest rates while bonds should offer alpha opportunities for investors focusing on relative value analysis.
Seeking value across the fixed income spectrum
Inflation is easing and the U.S. Federal Reserve is signaling rate cuts this year. While markets are pricing in these anticipated cuts and some economists are expecting a return to rock-bottom rates, PGIM Fixed Income sees bond yields stabilising at elevated levels but still offering investors long-term opportunities. ‘We think there’s room for the Fed to modulate rates lower and keep policy restrictive, yet we don’t see the federal funds rate dipping down to historical pre-Covid low levels,’ said Gregory Peters, co-chief investment officer at PGIM Fixed Income and portfolio manager of the PGIM Multi Asset Credit Fund. ‘Zero interest rate policy and negative rates are a relic of the past.’ PGIM Fixed Income’s base case for the U.S. economy is ‘weakflation’—a combination of sluggish growth and declining inflation that still hovers above the Fed’s 2% target rate—with recession still a possibility. The 10-year U.S. Treasury yield likely will remain in a long-term range between 3% and 5%. However the economic scenario plays out, Peters sees significant opportunities across multiple fixed income sectors.
“We see areas of value in high yield. It’s a very different picture versus 10 years ago”
Elevated yields and the end of central bank rate-hiking cycles may generate alpha opportunities when viewing bonds through a relative value lens
Important information FOR PROFESSIONAL INVESTORS AND/OR QUALIFIED INVESTORS AND/OR FINANCIAL INTERMEDIARIES ONLY. NOT FOR USE WITH OR BY PRIVATE INVESTORS. This is a marketing communication. Any research and analysis in this communication has been obtained by Artemis for its own use. Although this communication is based on sources of information that Artemis believes to be reliable, no guarantee is given as to its accuracy or completeness. Any forward-looking statements are based on Artemis’ current expectations and projections and are subject to change without notice. Issued by Artemis Fund Managers Ltd which is authorised and regulated by the Financial Conduct Authority.
Source 1. Effective Federal Funds Rate - FEDERAL RESERVE BANK of NEW YORK
Headline measures of inflation have fallen rapidly. They could be back below central-bank targets by the middle of 2024 in the UK, EU and the US. Admittedly, core inflation has been falling more slowly and services inflation has been sticky. I might be concerned if central banks weren’t focussing on these stickier measures of inflation – but they are. Meanwhile, forward-looking survey measures of pricing pressures suggest the downward trend in inflation is set to continue. So, while the final mile of bringing inflation down might take longer than some expect, I don’t think a slow glide path that brings it gradually back towards target is necessarily a bad thing.
I see potential for growth in the UK to surprise on the upside. The UK is in a fiscally weak position – but the UK’s consumers look relatively resilient. They have faced a tighter squeeze on disposable incomes than their US counterparts over the past two years but the real income differential has now swung significantly in favour of UK households. Inflation in the UK is falling rapidly even as wage growth, although slowing, is still tracking at around 6%. So workers should feel a boost to their ‘real’ incomes this year.
Yes. On a multi-year view, yield curves will steepen – it’s just a question of by how much. If we look at the two-year versus 10-year area of the curve, it is inverted across the US, EU and UK. We are heading into a rate-cutting cycle. Bond supplies, meanwhile, have never been higher in net terms and will remain elevated over the years to come. I don’t, however, believe it is necessarily a good idea to let steepening strategies dominate a bond portfolio’s risk profile – especially as most expressions of a steeper curve impose a heavily negative cost of carry. I think a steeper yield curve has become such a consensus view that the risk/reward in steepening strategies is not compelling.
That’s easy. In my view, shorter-dated bonds offer a compelling balance between risk and reward. Ultimately, I believe that interest-rate cuts will dominate and that yields will move lower across the yield curve once the cutting cycle begins. Shorter-dated bonds, meanwhile, are not influenced to the same extent as longer-dated bonds by the structural shift away from quantitative easing towards quantitative tightening. On top of this, the supply of bonds has increased markedly from the pre-Covid levels. This should act as a headwind to longer-dated bonds relative to their short-dated counterparts. While longer-dated bonds have greater potential to deliver superior returns under a hard-landing scenario, the balance between risk and reward very much favours the short end of the curve.
Which parts of the yield curve offer the best balance between risk and reward?
Do you still expect yield curves to steepen? If so, why?
Where do your views diverge most from consensus?
Is the final mile of bringing inflation down going to be the hardest and what could that look like?
In my view, the market may be underestimating two tail risks. One is that rates stay ‘higher for longer’. But I believe the market may also be being too optimistic in believing that global central banks will achieve a soft landing. There must be a possibility that economies have yet to see the true impact of the most aggressive rate-tightening cycle in decades. So, while we must acknowledge that market pricing is just a probability-weighted set of outcomes, the consensus view it implies – that a ‘soft landing’ has been achieved – may be too optimistic. Remember that, after a long period of zero interest rates, we’ve just had an interest-rate shock that saw the Fed pushing rates up by more than 5% in less than two years . If growth does deteriorate, rates may need to be cut more aggressively than the market expects.
Is the market being too optimistic about the prospect for rates to be cut in 2024? Could rates stay higher for longer?
“While longer-dated bonds have greater potential to deliver superior returns under a hard-landing scenario, the balance between risk and reward very much favours the short end of the curve”
Liam O’Donnell, macro and rates strategist, fixed income
“Inflation in the UK is falling rapidly even as wage growth, although slowing, is still tracking at around 6%. So workers should feel a boost to their ‘real’ incomes this year”
Liam O’Donnell, macro and rates strategist, Artemis Fixed Income Team
There are reasons for optimism and the potential for a UK growth surprise, says Liam O'Donnell, macro and rates strategist, fixed income
Important information For Professional Clients only and not to be distributed to or relied upon by retail clients. Past performance is not a guide to future performance. Opinions and examples represent our understanding of markets: they are not investment recommendations advice All data is sourced to Aegon Asset Management UK plc unless otherwise stated. The document is accurate at the time of writing but is subject to change without notice. Data attributed to a third party is proprietary to that third party and is used by Aegon Asset Management under licence. Aegon Asset Management UK plc is authorised and regulated by the Financial Conduct Authority. Adtrax 6523588.4; Expiry 31 May 2025
Investment Grade - Credit spread as % of yield
High Yield - Credit spread as % of yield
Source: Bloomberg 30 April 2009 to 29 March 2024. High Yield chart based on monthly spread as % of yield of the Bloomberg U.S. High Yield Corporate Index. Investment Grade chart based on monthly spread as % of yield of the Bloomberg U.S. Corporate Investment Grade Index.
Investment Grade Index - Yield to Worst (%)
High Yield Index - Yield to Worst (%)
Source: Bloomberg 30 April 2009 to 30 April 2024. High Yield chart based on monthly yield-to-worst data of the Bloomberg U.S. High Yield Corporate Index. Investment Grade chart based on monthly yield-to-worst data of the Bloomberg U.S. Corporate Investment Grade Index.
We are not bearish on the economic outlook per se. In fact, we think growth will be reasonable going forward. However, we are aware that corporate credit is a ‘mean reverting’ asset class. There is a minimum amount of default risk that needs to be baked into credit spreads in order to compensate us as investors for that risk. We never know what the future holds, but we know that when we see these levels of credit spreads, the cushion that we have in credit markets against any sort of exogenous shocks is minimal. In other words, it could take very little in the news for the market to suddenly wake up and panic and for credit spreads to sell off. Furthermore, at current spread levels, we think that the market is pricing in an immaculate disinflation ahead of us, the Federal Reserve manages to achieve the perfect soft landing, and inflation lands at 2% in the next year, while employment and growth remain resilient. This certainly is one of the possibilities. In fact, this scenario has increased in probability exponentially over the past 12 months. However, it is not the only scenario and there are a few more possible paths that the global economy can take. Not all of them have the same probability of occurring. What is important, however, is that any other economic scenario ahead of us could prove that either government bonds, high yield or investment grade credit (if not all) are incorrectly priced at current valuations.
Sources 1. Bloomberg. Based on monthly spread data of the Bloomberg U.S. High Yield Corporate Index
Why does this matter?
When we look at the bond market, we see multi-year wide index level yields. However, we also see multi-year tight credit spreads that could sell off in all but one scenario. This makes us want to: 1) definitely be exposed to bond markets in order to extract that yield that we have not seen in decades but, 2) we want to be exposed to the part of the markets that looks cheaper (yields), while minimizing exposure to the part of the market that looks like it has little further room to outperform (spreads) at this point in time. For this reason, in our strategic bond strategies, we maintain a headline yield of near 7% in the portfolios but have tactically reduced our credit risk exposure currently. We do not have an immediate catalyst for a spread sell-off, however we know that one always comes. We stand ready to increase our credit risk once we see better compensation for default risks, while in the meantime we continue to enjoy the overall high income that we can now extract from bonds.
Being very flexible is key to capturing attractive bond yields while navigating pitfalls
Four scenarios among many in 2024:
Possible scenarios
Within credit markets however, the level of the credit spread, which represents the premium for taking on additional risk of default, is eyewateringly low. Looking at the Bloomberg U.S. High Yield Corporate Index, credit spreads sit at 320bps . In an asset class such as high yield this is important as it is the asset class at most risk of defaults. That picture is exactly the same when we look at investment grade credit. This differentiation between yields and spreads has been very topical in the past 12 months. We realise that the attractiveness of fixed income is the all-in starting yields. It is important to be aware, however, that of this headline yield, credit spreads now represent a smaller proportion compared to history. To put this in perspective, credit spread is only 40% of the overall yield that we can now extract from the high yield market and the rest is from underlying government bonds. And the picture is even more stark in investment grade credit, where spreads are just 16% of the overall index yield.
Spreads are skinny, which may become an issue if we don’t achieve the immaculate disinflation
High yield and investment grade credit markets continue to look very attractive on a multi-year horizon. In fact, we find the market as attractive as it has been in nearly two decades. High yield looked great at the tail end of 2023 with the yield-to-worst on the Bloomberg U.S. High Yield Corporate Index pushing over 9%. At the end of April 2024, it is 8.1%, which is still above 15-year averages. Likewise, yields in investment grade credit also look appealing. The yield-to-worst on the Bloomberg U.S. Corporate Investment Grade Index remains above 5%, again a multi-year high. This still represents a good starting point and is also one of the main reasons we continue to be positive on bonds this year.
A strong starting point
Portfolio managers Alex Peltsheki and Colin Finlayson highlight how embracing flexibility in strategic bond funds can be the key to striking the balance between managing the potential downside risk in the case of negative events, whilst capturing a yield opportunity that has been rarely available in the last 15 years.
Whilst yields still offer a strong entry point for fixed income investors, some question whether tight credit spreads now leave credit markets priced for perfection
Important information For Professional Clients only and not to be distributed to or relied upon by retail clients. Past performance is not a guide to future performance. Opinions and examples represent our understanding of markets: they are not investment recommendations advice. All data is sourced to Aegon Asset Management UK plc unless otherwise stated. The document is accurate at the time of writing but is subject to change without notice. Data attributed to a third party is proprietary to that third party and is used by Aegon Asset Management under licence. Aegon Asset Management UK plc is authorised and regulated by the Financial Conduct Authority. Adtrax 6523588.5; Expiry 31 May 2025
We have seen some divergence emerge in policy emerge between the US Federal Reserve (the Fed), the European Central Bank (ECB) and the Bank of England. Indeed, it seems increasingly likely that the ECB will be the first major central bank to cut interest rates, starting in June, followed by the Bank of England. In Europe, the inflation picture is progressing well, with core inflation now at 2.7% (4.2% in the UK) and still trending lower. Energy is a large component of European inflation, as it is in the UK, and given the sharp fall in energy prices this should allow for a return to the ECB’s target inflation over the coming months. The question is when will the US follow? The Federal Reserve is comfortable with where policy rates are in the US right now, as it takes time to assess the economic and inflation outlook – but the Fed has recently indicated again that it still expects the next move will be lower. With that in mind, it should be encouraged by the inflation data released in May which showed a fall in inflation during April to 3.4%. This decline ended a four-month trend of higher-than-expected inflation and was greeted by a fall in government bond yields.
Domestic vs global dynamics
The fall in US inflation data is a welcome respite for markets gripped by uncertainty. But significant risks remain, including the impact of the final phase of the inflation reduction plan, ongoing geopolitical conflicts and a major election year. Further surprises, therefore, cannot be ruled out and divergence in terms of global central bank policy action could still lead to large interest rate differentials which may go beyond what is currently priced. Whilst this can present risk, it also creates opportunities for the active, nimble investor. In such dynamic or uncertain market environments, it is imperative to have an investment approach that can pull different levers at different points in the interest rate or credit cycle to generate solid risk-adjusted returns for clients. One of the most significant top-down drivers for our fixed income funds is the active management of interest rate risk. This includes the active management of overall headline duration in line with our views on the direction of interest rates, and the extent to which that is priced into market expectations. Determining the geographic composition of that interest rate risk, or identifying cross-market rates opportunities, also has the potential to drive additional alpha. In global strategic bond portfolios, this can open up a wealth of opportunities across interest rate markets globally – from US to UK to Australia or Canada. Whilst bottom-up security selection will always be the dominant driver of credit portfolios, the flexibility to shape duration risk in portfolios (particularly in investment grade corporate bond funds) can be a valuable, incremental source of returns at times of significant interest volatility and key market inflection points.
Exploiting change and embracing flexibility
After a two-year period where interest rate rises in major markets moved in lock step, 2024 has so far brought a more divergent picture for growth, inflation, and future central bank policy. Will this divergence continue? And how can fixed income investors navigate uncertainty and take advantage of interest rate opportunities as they arise? At the heart of this evolving landscape is the ongoing balancing act that central banks are striving to achieve - to anchor inflation and maintain monetary policy credibility. As we entered 2024, markets had priced-in up to six rate cuts in the US, with expectations for cuts also in the UK and the EU. Fast forward four months and the certainty that inflation had been beaten was gone. The US economy continued to defy gloomy expectations in the early months of the year and was progressing at near full speed, with the result that by the end of April markets had repriced the number of US Fed cuts for 2024 from six in January to just one.
Will inflation continue to surprise?
Markets continue to adjust their expectation for central bank policy substantially.
Change in rate cuts for 2024: now vs December 2023
Source: Aegon AM and Bloomberg as of 13 May 2024
US vs European inflation surprises
Source: Aegon AM and Bloomberg as at 30 April 2024
“It is imperative to have an investment approach that can pull different levers at different points in the interest rate or credit cycle to generate solid risk-adjusted returns for clients”
James Lynch, portfolio manager
To diverge, or not to diverge; that is the question. How can fixed income investors navigate uncertainty and take advantage of interest rate opportunities as they arise?
Stephen Snowden is manager of the Artemis Short-Duration Strategic Bond Fund
“While you can still make money by being short in the bond market, you not only need to be right – you need to be right quickly”
To make money being short you need to be right and you need to be quick
Probability of profiting %
Source: Bloomberg as at June 2021. Xover CDS is a European high yield index. Data from September 2006 to September 2020.
Source 1. The Investment Association: Fund Statistics.
A true absolute return fund attempts to remove all market directionality. In its purest expression, it does this by offsetting every long position with a short one. Shorting was cheap when interest rates – and bond yields – were low. (That was why we saw an avalanche of absolute return vehicles appearing in the era of QE and ZIRP). Today, however, QE is over and interest rates have normalised. Put simply, shorting bonds is vastly more expensive than it used to be.
Understandably, some of the money that has exited the absolute return bond sector appears to have gone into money market funds. But is cash really the best place to be today? Base rates are at levels last seen in 2006-07, a time of (seemingly) solid economic growth. That is not where the UK economy is in 2024. I believe base rates are far too high and the Bank of England has been clear that they need to fall. If not cash, then where should volatility-averse investors look? In the current economic environment, I would suggest that short-duration bond funds – with holdings in short-dated, investment-grade corporate bonds at their core – are the natural home for investors seeking a low-beta, cash-plus return. Yields on investment-grade bonds are now comfortably beating inflation. Focusing on short-duration bonds, meanwhile, seems a sensible precaution given the huge volumes of new bond issuance that are in the pipeline from governments across the West over the coming years. In the absence of quantitative easing, that tempers our enthusiasm for long-dated bonds. Buy short-dated investment-grade bonds today, however, and you’ll receive a very healthy yield in exchange for very little credit or interest-rate risk. As macroeconomic conditions evolve, market conditions and investment products change – but most people’s underlying investment goals do not. Some investors will always want a relatively low volatility fund that has the potential to deliver better returns than sitting in cash, particularly as interest rates start to fall. Absolute return bond funds were the right solution at the right time. But it is time to move on.
If ‘absolute return’ bond funds aren’t the answer, what are?
Shorting bonds became expensive
While you can still make money by being short in the bond market, you not only need to be right – you need to be right quickly. Remember that, when you own a bond, you continually receive income. But when you short a bond, you’re continually paying out income. This skews the odds of success against you. The longer you hold your short position, the more income you pay out – eating into the gains your clients will eventually see when (or if) your short position comes good. When interest rates are as high as they are today, shorting is something that should only be done fleetingly. Equally, when bond yields are high as they are today, it is simply illogical not to harvest that income. As Albert Einstein said, compound interest is the eighth wonder of the world. Now that interest rates have ‘normalised’, I believe that bond funds can still be built that outperform cash without exposing cautious investors to too much volatility. Today, however, I believe those funds need to be unashamedly directional.
In the aftermath of the financial crisis, a plethora of ‘absolute return’ bond funds appeared. At the time, they made perfect sense: base rates in the UK were historically low and investors had been terrified by the extreme volatility in financial markets. For much of the decade followed the global financial crisis, absolute return bond funds offered a useful solution. For cautious investors, they were the right product at the right time. But things change. Market conditions move on as economic conditions evolve. Investment approaches need to evolve too. Today, there is a strong case to be made that ‘pure’ absolute return bond funds make less sense than they did. Investors are clearly voting with their feet. Assets under management in the IA’s Targeted Absolute Return sector, once the IA’s third-largest sector, have more than halved, dragging it down to 16th place in the rankings . What changed?
Absolute-return bond fund popularity was fostered by an era of zero interest rates and QE following the GFC. But the shift to a new interest-rate regime may have made them a thing of the past
Important information FOR PROFESSIONAL INVESTORS AND/OR QUALIFIED INVESTORS AND/OR FINANCIAL INTERMEDIARIES ONLY. NOT FOR USE WITH OR BY PRIVATE INVESTORS. This is a marketing communication. Before making any final investment decisions, and to understand the investment risks involved, refer to the fund prospectus, available in English, and KIID/KID, available in English and in your local language depending on local country registration, from www.artemisfunds.com or www.fundinfo.com. CAPITAL AT RISK. All financial investments involve taking risk and the value of your investment may go down as well as up. This means your investment is not guaranteed and you may not get back as much as you put in. Any income from the investment is also likely to vary and cannot be guaranteed. Investment in a fund concerns the acquisition of units/shares in the fund and not in the underlying assets of the fund. Reference to specific shares or companies should not be taken as advice or a recommendation to invest in them. For information on sustainability-related aspects of a fund, visit www.artemisfunds.com. The fund is an authorised unit trust scheme. For further information, visit www.artemisfunds.com/unittrusts. Third parties (including FTSE and MSCI) whose data may be included in this document do not accept any liability for errors or omissions. For information, visit www.artemisfunds.com/third-party-data. Any research and analysis in this communication has been obtained by Artemis for its own use. Although this communication is based on sources of information that Artemis believes to be reliable, no guarantee is given as to its accuracy or completeness. Any forward-looking statements are based on Artemis’ current expectations and projections and are subject to change without notice. Issued by Artemis Fund Managers Ltd which is authorised and regulated by the Financial Conduct Authority.
In the high-yield market, bonds from smaller issuers have tended to outperform those from large issuers over the long term
Source: Artemis, Bloomberg, ICE BofA US High Yield Index as at 31 December 2023.
Note: small = bottom quartile of total face value issuer sizes; medium = 2nd and 3rd quartile of total face value issuer sizes; large = top quartile of total face value issuer sizes.
Yields on US high-yield bonds are attractive relative to their levels over most of the past decade
Source: ICE BofA US High Yield Index as at 30 April 2024.
All periods average gain
All periods average loss
3yr
Average gain / average loss
8%
6%
4%
2%
0%
-2%
-4%
All periods chance of gain
All periods chance of loss
Change of gain / loss
100%
90%
70%
60%
50%
40%
30%
20%
10%
80%
Source: Artemis, ICE BofA 1-5 Year BB-B Cash Pay High Yield Index as at 31 March 2024.
“At these valuations, high-yield bonds offer a useful source of diversification and an inflation-beating income stream”
“Medium and smaller-sized issuers have delivered higher returns than their larger counterparts since the inception of the global high-yield universe in 1997”
“At today’s yield levels, the high-yield market has historically delivered total returns in the mid-to-high single digits over the subsequent three years…”
Source 1. Artemis/ Bloomberg; ICE BofA US High Yield Index as at 30 April 2024.
Equities have undoubtedly had a great run. And, even if I wasn’t part of a business with a sizeable equity franchise, I wouldn’t want to downplay the attractions of (actively managed) equity funds. (Indeed, two of the funds I co-manage have healthy allocations to dividend-paying equities.) Equally, however, when yields have been at or around the levels we see today, returns from high-yield bonds have been comparable to those from equities. The US high-yield market currently yields 8.2%. And if we look at instances when the yield on the US high-yield index exceeded 8%, the average annualised return from high-yield bonds over the following three years has been 2.6% higher than returns from the MSCI World Index . That doesn’t mean you shouldn’t own equities – you probably should – but, at these valuations, high-yield bonds offer a useful source of diversification and an inflation-beating income stream.
If economic conditions are supportive for risk assets such as high-yield credit, why not just buy equities instead?
We see the yields on offer in short-dated BB and B-rated credit as being particularly compelling. As short-duration assets, they are all but free of interest-rate risk. Meanwhile, credit risk in this part of the market is low and we believe investors are being handsomely compensated for the modest risks they are taking. Alongside this we tend to focus on an area of the market most ignore – what we call ‘the undiscovered tail’. It is easier for active managers to gain an informational advantage by undertaking detailed analysis of bonds that receive less analyst coverage.
Which parts of the high-yield market are most attractive?
That’s good news for us: medium- and smaller-sized issuers have delivered higher returns than their larger counterparts since the inception of the global high-yield universe in 1997. In one way, this is similar to the so-called ‘smaller-companies effect’ in equities but with an important difference. In the case of small-cap equities, higher returns come at the cost of higher volatility. But the opposite is true in high-yield bonds. In the years in which the market saw the biggest losses – after the bursting of the dotcom bubble, the Global Financial Crisis and Covid – bonds from small issuers (not all of whom are necessarily ‘small companies’ from the equity market’s perspective) lost less than those from larger issuers. We therefore continue to bang the drum for investing in short-dated, high-yield bonds from small and medium-sized issuers. We simply don’t think their total-return potential is receiving enough recognition. In my (admittedly biased) view, active investors in high-yield bonds are currently presented with a very attractive opportunity. It’s one we intend to take.
In short, no. While high-yield bonds have generated healthy returns over the last year, the majority of those returns came in the form of income. We are still in a market where there is a lot of yield on offer. That’s the beauty of owning bonds in a post-QE world. In contrast to the long era of easy money, we can now rely on high levels of ongoing yield to provide our clients with an attractive total return. The view of my colleagues on Artemis’ fixed-income team – and it’s a view I share – is that bond markets in general continue to be attractively priced, with yields that compare favourably with the last 15 years. Central bank rates have likely peaked, and the debate now is firmly around the timing rather than the possibility of looser monetary policy. This is a fundamentally supportive backdrop for fixed income as a whole. Within that, however, I firmly believe that conditions are particularly propitious for high-yield bonds. Perhaps I’m bound to say that. But consider this: at today’s yield levels, the high-yield market has historically averaged total returns in the high single digits over the subsequent three years. Timing the market is always hard. But at these yield levels, there is a real opportunity cost to walking away from this income.
High-yield bonds have delivered impressive returns over the last year. Have investors missed the rally?
Q&A with Artemis’ Jack Holmes on the ‘undiscovered tail’ of smaller issuers that deliver superior returns with less downside in the short-dated high-yield space
Jack Holmes co-manages the Artemis Funds (Lux) – Global High Yield Bond, Artemis Funds (Lux) – Short-Dated Global High Yield Bond and the Artemis Short-Duration Strategic Bond Fund.
Important information This is for investment professionals only and should not be relied upon by private investors. The value of investments and the income from them can go down as well as up so you may get back less than you invest. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes. The value of investments in overseas markets may be affected by changes in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. Rising interest rates may cause the value of your investment to fall. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Sub-investment grade bonds are considered riskier bonds. They have an increased risk of default which could affect both income and the capital value of the fund investing in them. They can also use financial derivative instruments for investment purposes, which may expose the funds to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Investments should be made on the basis of the current prospectus, which is available along with the Key Investor Information Document (Key Information Document for Investment Trusts), current annual and semi-annual reports free of charge on request by calling 0800 368 1732. Issued by FIL Pensions Management, authorised and regulated by the Financial Conduct Authority. Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM0424/386592/SSO/NA
Corporate bonds outperform cash in rate cutting cycles over 3yrs and 5yrs
Source: Fidelity International, Bloomberg, March 2024. 1-5yr Corporate Bonds = ICE BofA 1-5 Year Eurosterling Index; All Maturity Corporate Bonds = ICE BofA Euro-Sterling Index; Government Bonds = ICE BofA UK Gilt Index; High Yield Corporate Bonds = ICE BofA US High Yield Index used for the first cutting cycle, while ICE BofA Global High Yield Index (GBP Hedged) was used for the remaining cycles; Equities = FTSE 100. Cash rate was ICE BofA British Pound 6-Month Deposit Bid Rate Constant Maturity Index for the first cutting cycle and then the ICE BofA Sterling 1-Month Deposit Bid Rate Constant Maturity Index for the remaining 3. Uses 4 Bank of England interest rate cutting cycles between 1995 and 2024, starting in December 1995, October 1998, February 2001 and December 2007 respectively. Returns start 3-months prior to first cut to incorporate the impact of expectations.
1-5yr Corporate Bonds
All Maturity Corporate Bonds
All Maturity Government Bonds
High Yield Corporate Bonds
Equities
3.6
3yrs
5yrs
1.7
0.9
-19.8
-37.3
-52.7
-8.8
7.8
14.2
5.3
Investors with high cash allocations tend to be risk averse, so what about the worst-case outcome, and over a longer time horizon? As the chart below shows, over a 3yr holding period, the worst excess return over cash from 1-5yr corporate bonds in the cutting cycles we identified was +3.6%. This was in the 3yrs following October 1998, when cash delivered +19.2% returns while 1-5yr corporate bonds delivered +22.8% returns. In the other 3 cutting cycles, 1-5yr corporate bonds outperformed cash by even more over 3yrs (with this outperformance ranging from +5.4% to +11.8%). For high yield and equities, the worst-case outcomes were -19.8% and -37.3% respectively over 3yrs. For high yield this was in the 3yrs post October 1998 when high yield delivered -0.6% returns versus cash at +19.2%. For equities, this was in the 3yrs following February 2001, when the FTSE 100 was down 23.8% versus cash up at +13.5%. It is also notable that the FTSE 100 was down in absolute terms over 3yrs in 3 of the 4 cutting cycles we identified. The average 3yr return from the FTSE 100 versus cash in the four cases we identity is -7.4%, this is because central banks tend to cut into weakness to stimulate the economy. Over 5yrs following a cutting cycle, all maturity corporate bonds stand out as a relatively safe option based on history with the worst-case excess return over cash at +14.2%. This was in the 5yrs following December 1995 when cash delivered +36.7% return versus all maturity corporate bonds at +50.9%. All maturity government bonds come in second, largely due to its higher duration profile (at 9.3yrs) relative to 1-5yr corporate bonds (at 2.6yrs). For the risk averse investor looking to outperform cash in the medium term we think corporate bonds are set up well as the BoE starts to cut. Furthermore, with the yield curve inverted, 1-5yr corporate bonds may be an attractive option over 3yrs. Over the longer term (5yrs), all-maturity corporate bonds standout well as the curve normalises and investors can once again benefit from higher yields for taking more risk via longer dated bonds.
Can corporate bonds offer a safe option versus cash over the longer term?
The negative drivers of bond returns - inflation and interest rate hikes - are abating which sets fixed income up well for the period ahead. Inflation is moderating and central bankers are now talking about the timing of interest rate cuts. Accordingly, the market is now pricing in the first full 0.25% cut from the Bank of England (BoE) by August 2024, with the chances of a cut earlier in June. Ahead of a cutting cycle cash rates are elevated because, like today, they tend to have followed a series of rate hikes which optically makes cash look attractive from a forward-looking return standpoint. So, why bother with corporate bonds if you can get more-or-less the same level of yield from cash? Firstly, cash is more exposed to reinvestment risk. Reinvestment risk refers to the risk that investors are unable to reinvest cashflows, such as coupons or principal, at a rate comparable to the current rate of return. As rates fall, cash and money market instruments are more exposed to this risk given these securities often have maturities measured in days (rather than years). This means cash yields (and returns) more closely follow central bank rates lower relative to bonds. On the flipside, fixed income securities have a fixed income for a longer period of time and the value of those cash flows rises as interest rates fall. This impact is known as duration risk, a measure of the sensitivity of the price of a debt instrument to a change in interest rates (yields fall, prices rise). So, if central banks are due to cut rates, time to add as much duration as possible? Not quite, for two reasons. Firstly, markets tend to price in cuts before they happen and so the extent of the rally in bonds during a cutting cycle depends on how many cuts were already priced in. Secondly, as we highlight here, if the yield curve is inverted, like today, then short dated bonds can outperform longer dated bonds as the curve normalises despite having less duration risk. In these unique circumstances your position on the curve can be a more powerful driver of return than the absolute level of duration. The curve inversion makes us particularly constructive on 1-5yr corporate bonds.
Is it time to consider corporate bonds?
At the time of writing, assets in money market funds are close to $6tn, having doubled from the asset level pre-pandemic. This makes sense, for investors used to almost zero rates for the decade following the Global Financial Crisis the prospect of >5% yields from low-risk cash investments was, and is, attractive. The case for cash remains strong because there will always be a need for cash, particularly for those investors prioritising liquidity and capital preservation. However, some investors may be allocating to cash for the prospect of outperformance versus other asset classes. While this was the right call in recent years, those investors might want to consider corporate bonds looking ahead.
“For the risk averse investor looking to outperform cash in the medium term we think corporate bonds are set up well as the BoE starts to cut”
Ben Deane, investment director, Fixed Income
“The negative drivers of bond returns - inflation and interest rate hikes - are abating which sets fixed income up well for the period ahead”
A flight to safety spurred by the Federal Reserve's aggressive rate hikes has left a record amount of capital parked in money market funds. However, with rate cuts ahead, investors may want to explore more productive uses for their cash holdings
Important information This is for investment professionals only and should not be relied upon by private investors. The value of investments and the income from them can go down as well as up so you may get back less than you invest. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Reference to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes. The value of investments in overseas markets may be affected by changes in currency exchange rates There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. Rising interest rates may cause the value of your investment to fall. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Sub-investment grade bonds are considered riskier bonds. They have an increased risk of default which could affect both income and the capital value of the fund investing in them. They can also use financial derivative instruments for investment purposes, which may expose the funds to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Investments should be made on the basis of the current prospectus, which is available along with the Key Investor Information Document (Key Information Document for Investment Trusts), current annual and semi-annual reports free of charge on request by calling 0800 368 1732. Issued by FIL Pensions Management, authorised and regulated by the Financial Conduct Authority. Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. FIPM 8139
Confidence in the fiscal sustainability of the US is crucial and the recent rapid rise in the price of gold suggests that this should not be taken for granted. Over the past two years, the gold price has diverged from its long-held negative correlation with real yields and jumped higher this year. This could be an early sign that globally, US debt burdens are starting to chip away at the once rock-solid confidence in US fiscal policy. This is a gradual and long-term process, but we could be on this trajectory unless policymakers recognise and address the threat. In the short term, US treasury yields could continue to float upwards as inflation stays sticky, but in the medium term we expect some moderation in fiscal policy, which would put the US economy under pressure and support duration. In the very long term, the current fiscal path of the US is unsustainable.
The fiscal deficit must moderate otherwise the debt burden and debt service costs will continue to climb. The bond market will demand increasingly higher yields to compensate for lending to the government, and other factors including geopolitical events or political strife such as debt ceiling disputes could add to concerns. The conundrum for the government is that when the fiscal deficit is reduced, it could trigger a recession. In the meantime, the Fed will taper quantitative tightening from June, which is the first acknowledgement that things might break (i.e. refinancing problems) if yields keep rising. We may even see the prospect of unorthodox measures such as yield curve control to stop debt service costs from spiralling upwards.
US inflation continues to be higher than expected and the Fed has shifted course once more, signalling higher for longer rates. Bond markets are yet again scrambling to incorporate the changing policy direction. We have gone from six rate cuts forecast in 2024 to just one in the space of four months. The Fed’s guidance on the inflation outlook has not been consistent. It initially justified a lack of action given that inflation was transitory in 2021, to playing catch up with rapid policy tightening in 2022, to shifting to a soft landing and gradual disinflation in 2023, to the current higher for longer narrative. I’d argue that these directional changes were somewhat predictable given that the Fed appears to be misdiagnosing the underlying cause of inflation - or at least not vocalising it for whatever reason. The restrictive monetary stance of the Fed faces a challenging obstacle - the loose fiscal policy of the government. The fiscal budget deficit stands at around 6.3% of GDP - a level that we’re more accustomed to in times of war or deep recession, not during high employment and resilient growth. This level of liquidity in the system is helping to keep risk assets rising and adding to upward pressure on yields. But until these fiscal deficits are reined in, we may have ongoing sticky inflation and upside surprises as I’ve suggested before in these commentaries. However, any fiscal prudence is unlikely to occur before the US election.
“Confidence in the fiscal sustainability of the US is crucial and the recent rapid rise in the price of gold suggests that this should not be taken for granted”
Steve Ellis, global CIO Fixed Income
“Until fiscal deficits are reined in, we may have ongoing sticky inflation and upside surprises”
The US fiscal deficit must moderate otherwise the bond market will demand increasingly higher yields to compensate for lending to the government
For Professional Investors only. All investments involve risk, including the possible loss of capital. In the United Kingdom, information is issued by PGIM Limited with registered office: Grand Buildings, 1-3 Strand, Trafalgar Square, London, WC2N 5HR. PGIM Limited is authorised and regulated by the Financial Conduct Authority (“FCA”) of the United Kingdom (Firm Reference Number 193418), and with respect to its Italian operations by the Consob and Bank of Italy. In the European Economic Area (“EEA”), information may be issued by PGIM Netherlands B.V., PGIM Limited or PGIM Luxembourg S.A. depending on the jurisdiction. PGIM Netherlands B.V., with registered office at Gustav Mahlerlaan 1212, 1081 LA, Amsterdam, The Netherlands, is authorised by the Autoriteit Financiële Markten (“AFM”) in the Netherlands (Registration number 15003620) and operates on the basis of a European passport. FOR IMPORTANT INFORMATION RELATED TO RISKS AND DISCLOSURES PLEASE VISIT PGIM.COM/UCITS/DISCLOSURE. © 2024 Prudential Financial, Inc. (PFI) and its related entities. PFI of the United States is not affiliated with Prudential plc, incorporated in the United Kingdom or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom. PGIM and the PGIM logo are service marks of PFI and its related entities, registered in many jurisdictions worldwide. 3562778.
Short-term interest rates jumped in the early months of the year as investors revised expectations for rate cuts. Longer rates moved modestly by comparison, suggesting that the motivation to lock in yield for the long term endures among investors. Indeed, inverted yield curve conditions, which many interpret as a harbinger of recession, could just as credibly be attributed to investor recognition that yields are back near generational highs. The desire to secure current yields over the long term is strong enough for investors to forgo a bit of near-term income upside. Moreover, assets invested in money-market funds as a percentage of nominal GDP are about one-third higher than normal. This potential source of inflows awaits at a time when equity and real estate allocations reflect the benefits of appreciation in recent years, a period during which restrictive monetary policy weighed on fixed income. Given aging demographics, bonds seem likely to attract supportive demand amid rebalancing trends.
Yearning for yield
Precarious geopolitical conditions against a backdrop of tighter spreads amplify the importance of credit selection in maintaining portfolio resilience. At the same time, uncertainty continues to contribute to the opportunity set for adding value via issue, sector, term structure and currency positioning. Conditions call for the foresight and flexibility that an active approach can provide in managing risk and reward. It is not a textbook bull market, but the situation is favorable, nonetheless. Fixed income valuations are appealing versus other asset classes, adding to the category’s risk-hedging potential at a time when uncertainty is also contributing to opportunities to generate alpha. Bonds continue to reside ‘in the buy zone’ with long-term rates near secular peaks in the rate-hiking cycle’s wake. We expect rangebound long-term rates and credit spreads, with some potential for spread narrowing amid otherwise conducive conditions for adding value through active management. Against that backdrop, the highest yields in a generation should transform into realised returns over time. Not much is new in terms of the factors underpinning fixed income’s potential to deliver attractive risk-adjusted returns as a new cycle takes shape. The timeline appears to be the biggest change, and we believe investors who take advantage of the extended opportunity to secure today’s yields over the long term will be glad they did.
Active attention required
Investment grade bonds staged a late-year rally in 2023 after the Federal Reserve signaled the likelihood of rate cuts during the year ahead. Then, as 2024 got underway and the path to a policy pivot took new turns, high yield corporates and hard currency emerging markets attracted investor attention. Central bank tenor has changed amid signs that inflation is tempered but not tamed. Rate-cut timing is back up for debate as quantifying ‘higher for longer’ becomes more challenging. Still, as sentiment shifts with incremental data points, the investor appetite for yield remains robust. That seems unlikely to change anytime soon. Sure, mini cycles should continue to unfold as investors await definitive action, but the foundation for a bull market in which returns derive from yield appears firmly established. Yields remain more enticing than they have been during most of the past two decades, central banks appear to be done tightening, and long-term rates are probably past their peaks for the cycle.
“Mini cycles should continue to unfold as investors await definitive action, but the foundation for a bull market in which returns derive from yield appears firmly established”
Active foresight and flexibility is needed to manage the opportunities in the current bond bull market
References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The securities referenced may or may not be held in the portfolio at the time of publication and, if such securities are held, no representation is being made that such securities will continue to be held. The views expressed herein are those of PGIM investment professionals at the time the comments were made, may not be reflective of their current opinions, and are subject to change without notice. Neither the information contained herein nor any opinion expressed shall be construed to constitute investment advice or an offer to sell or a solicitation to buy any securities mentioned herein. Neither PFI, its affiliates, nor their licensed sales professionals render tax or legal advice. Clients should consult with their attorney, accountant, and/or tax professional for advice concerning their particular situation. Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. The manager has no obligation to update any or all such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy. Any projections or forecasts presented herein are subject to change without notice. Actual data will vary and may not be reflected here. Projections and forecasts are subject to high levels of uncertainty. Accordingly, any projections or forecasts should be viewed as merely representative of a broad range of possible outcomes. Projections or forecasts are estimated based on assumptions, subject to significant revision, and may change materially as economic and market conditions change. For Professional Investors only. All investments involve risk, including the possible loss of capital. In the United Kingdom, information is issued by PGIM Limited with registered office: Grand Buildings, 1-3 Strand, Trafalgar Square, London, WC2N 5HR. PGIM Limited is authorised and regulated by the Financial Conduct Authority (“FCA”) of the United Kingdom (Firm Reference Number 193418), and with respect to its Italian operations by the Consob and Bank of Italy. In the European Economic Area (“EEA”), information may be issued by PGIM Netherlands B.V., PGIM Limited or PGIM Luxembourg S.A. depending on the jurisdiction. PGIM Netherlands B.V., with registered office at Gustav Mahlerlaan 1212, 1081 LA, Amsterdam, The Netherlands, is authorised by the Autoriteit Financiële Markten (“AFM”) in the Netherlands (Registration number 15003620) and operates on the basis of a European passport. FOR IMPORTANT INFORMATION RELATED TO RISKS AND DISCLOSURES PLEASE VISIT PGIM.COM/UCITS/DISCLOSURE. © 2024 Prudential Financial, Inc. (PFI) and its related entities. PFI of the United States is not affiliated with Prudential plc, incorporated in the United Kingdom or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom. PGIM and the PGIM logo are service marks of PFI and its related entities, registered in many jurisdictions worldwide. 3600573
Source: Chart top: Bloomberg as of May 2024. Chart bottom: PGIM Fixed Income. * "Yield is Destiny; Bonds are Back," The Bond Blog, PGIM Fixed Income, December 20, 2022.
In contrast to equities – where price-earnings ratios are high and earnings yields are low – the revaluation in bonds has taken yields back to levels not seen for more than a decade. For long-term investors, this is a critical point: if past is prologue over the long term, these yields are likely to translate into returns.
With the return of the “High Plains Drifter” regime of elevated bond yields, the investment landscape continues to shift. As a caveat, it is worth noting the obvious: we cannot rule out a bearish scenario playing out from current yield levels, in absolute or relative terms, vs. cash and stocks. But as equities scrape record highs and central bank policy rates crest, the preceding pictures support the case for diversifying into bonds.
Bond yields sit at levels not seen in over a decade (Bloomberg U.S. Aggregate yield to worst; (%)
Higher yields signal higher returns ahead, a la 2002*(%)
Cash vs. Bonds during quarters when equities declined by at least 5% (1962-Present)
Source: PGIM Fixed Income, Haver as of April 2024.
Average return (%)
Returns based on Fed regime (%)
2.5
2.0
1.5
1.0
0.5
0.0
Cash
10-year Treasury note
Source: PGIM Fixed Income.
0.7
0.6
0.4
0.3
0.2
0.1
Fixed income performance vs. equities improves when bond yields > earnings (Sharpe ratio)
Earnings yield > Bond yield
Bond yield > Earnings yield
Stocks
IG corporates
Treasuries
Source: Bloomberg, Haver, PGIM Fixed Income as of April 2024. Note: Sharpe ratios calculated from rolling 12-month forward excess returns (over cash) from relative starting valuation. The line on the left-hand side chart represents the 45-degree line, which delineates whether bond yields are higher than earning yields. Trailing earnings yields are used for the analysis.
Forward risk-adjusted returns favour fixed income when bonds yields are higher than earnings yields
10-year U.S. Treasury yield (%)
Bond yield > Earning yield
S&P 500 earnings yield (%)
Equity vs. bond yields (1970s- present; %)
Data (1970 - Present)
Correlation of starting yield with forward returns (1962-Present)
Source: PGIM Fixed Income, Haver as of May 2024. Note: Forward returns calculated by reinvesting in each instrument at a monthly frequency. Non-overlapping windows are used for each forward return horizon.
Starting bond yield is more correlated with forward returns as the horizon increases
5-year Treasury note
Starting cash yield is less correlated with forward returns as the horizon increases
Forward return horizon
Cash may seem like the preferred option amidst the inverted yield curves. But, over time, the certainty around expected cash returns logically declines. In contrast, given bonds’ long durations and longer maturities, they provide a level of certainty or confidence for a targeted level of return. Therefore, cash may actually be the riskier option over the long term.
Cash may not outperform over the long term
Whether you’re looking at the last few years, or the last century, equities might seem like the place to be. Notwithstanding the excellent wealth building capacity of stocks over the ultra-long run, in the current context, it’s worth considering that the recent repricing of bonds has taken yields to generational highs; the same cannot be said of equity valuations. For example, comparing the earnings yield of the S&P 500 with the 10-year Treasury yield shows that stocks have lost their relative valuation advantage vs. bonds. Additionally, bonds have tended to be much more efficient – e.g., higher Sharpe ratios – from the current relative yield levels.
Relative equity valuations raise a case for bonds
While over the very long term, equities may post the highest total returns, it is worth keeping in mind that their near-term risks can be high. Even over 10- to 15-year horizons, there may be periods when equity returns only match, or even fall short of, the returns on bonds or cash. Which is the best shock absorber, cash or bonds? When looking at quarters when stocks were down 5% or more, bonds generally posted higher returns than both stocks and cash. Furthermore, bonds’ outperformance widens when the Fed is on hold or cutting – which seems to be the kind of environment we are in now.
When stocks fall, bonds have been a better shock absorber than cash.
The overall fixed income backdrop looks promising
“It's worth considering that the recent repricing of bonds has taken yields to generational highs; the same cannot be said of equity valuations”
With yields up at levels not seen in more than a decade, bonds are definitely catching the eye of investors. But with equities delivering strong gains and Treasury curve inversions incentivising investors to idle in cash, will bond returns be competitive? In the current market environment, we see a compelling case for rebalancing into bonds vs. both stocks and cash. The figures below tell the story, highlighting the pros and cons of cash, bonds and stocks, as well as their roles in portfolio construction. Before jumping into the figures, a few conclusions to set the scene:
1. True, cash rates remain high. But unlike bonds, the returns from cash over the long term are highly uncertain. And to that point, central banks are preparing to cut rates. 2. Equity valuations look full relative to bonds. This is not so much a knock against stocks, but this configuration has historically signaled that bonds are set to deliver better-than-average returns and Sharpe ratios. 3. In environments where central banks are on hold or cutting rates, bonds have historically been good shock absorbers, on average delivering solidly positive returns in quarters when equities experience steep declines.
With investors capitalising on recent stock gains or still idling in cash, what's the case for bonds?
2000
2005
2010
2015
2020
One year Two years Three years Four years Five years
0.99 0.94 0.91 0.85 0.73
0.66 0.82 0.89 0.93 0.96
Important information FOR PROFESSIONAL INVESTORS AND/OR QUALIFIED INVESTORS AND/OR FINANCIAL INTERMEDIARIES ONLY. NOT FOR USE WITH OR BY PRIVATE INVESTORS. This is a marketing communication. Before making any final investment decisions, and to understand the investment risks involved, refer to the fund prospectus, available in English, and KIID/KID, available in English and in your local language depending on local country registration, from www.artemisfunds.com or www.fundinfo.com. CAPITAL AT RISK. All financial investments involve taking risk and the value of your investment may go down as well as up. This means your investment is not guaranteed and you may not get back as much as you put in. Any income from the investment is also likely to vary and cannot be guaranteed. Investment in a fund concerns the acquisition of units/shares in the fund and not in the underlying assets of the fund. Reference to specific shares or companies should not be taken as advice or a recommendation to invest in them. For information on sustainability-related aspects of a fund, visit www.artemisfunds.com. The fund is a sub-fund of Artemis Funds (Lux). For further information, visit www.artemisfunds.com/sicav. For changes made to the Artemis Funds (Lux) range of Luxembourg-registered funds since launch, visit www.artemisfunds.com/historic-changes. Third parties (including FTSE and MSCI) whose data may be included in this document do not accept any liability for errors or omissions. For information, visit www.artemisfunds.com/third-party-data. Any research and analysis in this communication has been obtained by Artemis for its own use. Although this communication is based on sources of information that Artemis believes to be reliable, no guarantee is given as to its accuracy or completeness. Any forward-looking statements are based on Artemis’ current expectations and projections and are subject to change without notice. Issued by: Artemis Investment Management LLP which is authorised and regulated by the UK Financial Conduct Authority.
David Ennett co-manages the Artemis global high yield bond, short-dated global high yield bond, strategic bond and high income strategies.
“The use of ‘yield-to-worst’ has generally been a good indication of the actual yield on a high-yield bond fund, but of late it is at odds with what we are seeing in the market”
David Ennett, fund manager
ICE BofA Merrill Lynch Global High Yield Constrained Index price splits (% of face value)
Source: ICE BofA indicies as at 31 March 2024.
<50
50-75
75-100
100+
Jan-98
May-01
Aug-04
Nov-07
Feb-11
Jun-14
Sep-17
Dec-20
Mar-24
Source 1. Artemis as at 31 March 2024.
Unlike with investment grade debt, high-yield bonds can be ‘called’ or redeemed before they mature. This usually takes place between one and three years ahead of the redemption date, at a cash price of 100 – although this can be higher. There are three reasons why high-yield issuers call their bonds early, which have nothing to do with the cost of their debt:
For an example of what this means in practice, let’s look at a 6.5% 10-year October 2025 bond issued by Australian mining contractor, Perenti. For much of the second half of 2023, the bond was trading slightly below par, at $98.5, and this is the price we added to our positions at. At this price, its yield-to-worst stood at 7.41%, while its spread was 310bps over US Treasuries. This yield-to-worst figure assumed that the bond would be outstanding until its final maturity in October 2025. A decent yield for a very strong high-yield issuer, but not much more than that. In its August 2023 earnings call, Perenti’s chief financial officer said: “Our US dollar high-yield bonds mature in October of 2025, and thus we’ll be looking to refinance prior to them going current, in October of 2024.” The company had clearly announced its intention to call the bond at least 12 months early because it didn’t want it to ‘go current’, or become a short-term liability. In this early-call scenario (in which the bond would be called at 100 in October 2024 rather than October 2025), investors could now expect a yield-to-call of 8.55% and a spread of 423bps above US Treasuries. Yet the official yield-to-worst figure was stuck at 7.41% because it was still, in theory, the lowest yield you could get. We were then in the position where we had to report a yield figure to worst that we were all but certain was worse than the one we would actually receive.
The impact on total returns
The ‘actual’ yield
It feels at times that bond funds try their best to put you off. There are many versions of a simple concept such as ‘yield’ that investors need to wade through to get an idea of how a fund stacks up in terms of return potential. One we use often in high-yield investing is the yield-to-worst, a phrase that does little to dispel bond managers’ reputation for being pessimistic. According to Artemis’ carefully worded, compliance-approved definition, it “reflects the lowest potential yield based on the current price of securities within the portfolio under the assumption there are no defaults”. Essentially, it is saying that while there are a range of potential return outcomes for every bond based on when they are called, we are going to assume that they all mildly disappoint and return the minimum in every case. Not the most compelling call to arms for the asset class, but surely a sensible approach at least. If you are wrong, let it be that you made a bit more than expected. At present, the ‘yield-to-worst’ on the factsheet for our global high yield fund stands at 7.79% under this most pessimistic of scenarios. Following the reset in global yields over the past two years, most bonds are trading below par ($100). This is unusual in a market that has historically traded at, or just above, par. The use of ‘yield-to-worst’ has generally been a good indication of the actual yield on a high-yield bond fund, but of late it is at odds with what we are seeing in the market.
• • •
Early calls are not a sporadic occurrence. Research from the Bank of America shows that over the past 12 months, high-yield bonds have on average been called more than 1.3 years ahead of maturity. This figure has stood between 1.1 and 1.8 years over the past decade. Today, there are more bonds trading below 100 – meaning there is more upside to being redeemed at this cash price – than at any time in the past 25 years outside of the Global Financial Crisis or the bursting of the Dotcom Bubble. But with bonds being called early, holders are receiving a further boost to yield and total return that is not being reflected in yield-to-worst figures.
Bank facilities (such as overdrafts and revolving credit facilities) normally have provisions around current ratios (current assets divided by current liabilities). Bonds that enter the final year until redemption become current liabilities, pushing current ratios outside the limits of what banks are comfortable with. Hence the need to keep longer-term debt at more than 12 months to maturity. Liquidity considerations are a focus of ratings agencies, which view high-yield issuers unfavourably if they fail to repay/refinance a bond well before it reaches the final year of its life. Corporate management prudence – high-yield companies are more reliant on markets being open to refinance any issues that are close to redemption. This means chief financial officers don’t want to let bonds get too close to their maturity and be exposed to market conditions on a specific date in the future.
High-yield bond funds are currently presenting an overly pessimistic scenario when it comes to income expectations, writes David Ennett
It feels at times that bond funds try their best to put you off. There are many versions of a simple concept such as ‘yield’ that investors need to wade through to get an idea of how a fund stacks up in terms of return potential. One we use often in high-yield investing is the ‘yield-to-worst,’ a phrase that does little to dispel bond managers’ reputation for being pessimistic. According to Artemis’ carefully worded, compliance-approved definition, it “reflects the lowest potential yield based on the current price of securities within the portfolio under the assumption there are no defaults”. Essentially, it is saying that while there are a range of potential return outcomes for every bond based on when they are called, we are going to assume that they all mildly disappoint and return the minimum in every case. Not the most compelling call to arms for the asset class, but surely a sensible approach at least. If you are wrong, let it be that you made a bit more than expected. At present, the ‘yield-to-worst’ on the factsheet for our global high yield fund stands at 7.79% under this most pessimistic of scenarios. Following the reset in global yields over the past two years, most bonds are trading below par ($100). This is unusual in a market that has historically traded at, or just above, par. The use of ‘yield-to-worst’ has generally been a good indication of the actual yield on a high-yield bond fund, but of late it is at odds with what we are seeing in the market.
In the event, the company chose to call half of the bonds even earlier, in April 2023, and at a premium of 101.75. This meant it paid investors more than the amount outstanding and in addition, its new debt was actually more expensive than the debt it was retiring. This resulted in an annualised return north of 14% on the debt being retired; a far cry from its 7.41% yield to worst. It may seem crazy to pay a premium to roll into more expensive debt, but it simply shows that corporates are very prudent in managing their debt and active investors can exploit this. On a side note, you may be surprised to hear that when Perenti’s chief financial officer made his announcement, effectively telling the market the bond was undervalued, this didn’t move its price. This is because large areas of the global high-yield market are completely inefficient. We’ve explained why in a separate article – the reasons are many, varied and really quite confusing, and let’s face it, you’ve probably had enough of that from high-yield bonds for one day.
“With bonds being called early, holders are receiving a further boost to yield and total return that is not being reflected in yield-to-worst figures”
The labour party and Keir Starmer have been rightly criticized for lack of specificity on tax and spending plans, and although it’s almost certain that they will win a large majority, what is less certain is what they are likely to do when in power. Encouragingly from a Gilt market perspective they have been careful to emphasis caution with respect to UK finances, positioning themselves as a safe pair of hands after the calamitous reign of Liz Truss and the conservatives. In reality - what will likely trouble the Gilt market over the next few years has already been put in place long before Keir Starmer will enter number 10 Downing Street.
Liam O’Donnell, rates and strategy lead, Artemis Fixed Income Team
James Lynch, fixed income investment manager, Aegon Asset Management
There are more positives for gilts than negatives if the polls are correct in pointing to a large Labour victory. The new parliament with a large Labour majority will bring a sense of stability; most likely, five years of the same chancellor and prime minister should mean a coherent fiscal plan that is unlikely to be deviated from in short order. If Labour wins, we will see a spending review first, followed by an autumn budget in October/November 2024. The potential new government ‘gets it’ in terms of there being no quick fixes to a return to growth, and they know they cannot spend their way to growth via borrowing in the gilt market. At the margin, there will likely be an increase in tax take as extra investment will be needed in some public services, and the plan for GB energy. There will be headwinds for the gilt market this year, including another record year of gilt supply coming, but if the polls are correct, a move towards political stability will be most welcomed by the market.
Against a backdrop of nearly 100 elections due to take place in 2024, the UK election looks to be a comparatively stable and predictable affair. According to polls, Labour is set to win. The question is by how much. That will have a bearing on how bold the party can be in terms of implementing its reform agenda, for example with respect to planning or the UK’s relationship with the EU. From a near term macro perspective, however, the election is likely to be rather less consequential. Both parties seem to have learned the lesson of the 2022 mini budget and are preaching fiscal prudence. Whatever the outcome, we expect that fiscal will remain relatively constrained in the UK over the foreseeable future.
Katharine Neiss, chief european economist, PGIM Fixed Income
A Labour victory with a substantial majority seems the most likely outcome for the UK General Election. However, both the Conservative and Labour party have refrained from an expansive fiscal policy stance meaning there has been little to upset Gilt markets so far. One could argue there has been more to be concerned with elsewhere in Europe, notably France. We therefore expect the election outcome to have a limited long-term impact on Gilts. For us, the key is always the likely impact on the future path of policy rates. Once the election is out of the way, attention will quickly turn to the data, and with inflation continuing to moderate, we expect the BoE to ease later this year. We would likely use any cheapening in Gilts to add on weakness.
Kris Atkinson, portfolio manager, Fidelity Short Dated Corporate Bond Fund
How will the election impact UK gilts?
Important information For Professional Clients only and not to be distributed to or relied upon by retail clients. Responsible investing is qualitative and subjective by nature and may not reflect the beliefs or values of any one particular investor. Past performance is not a guide to future performance. Opinions and examples represent our understanding of markets: they are not investment recommendations advice. All data is sourced to Aegon Asset Management UK plc unless otherwise stated. The document is accurate at the time of writing but is subject to change without notice. Data attributed to a third party is proprietary to that third party and is used by Aegon Asset Management under licence. Aegon Asset Management UK plc is authorised and regulated by the Financial Conduct Authority. Adtrax 6523588.6; Expiry 30 June 2025
Whilst an increasing focus for investors, climate risk is not priced into bond markets. Investors are not paid a premium yet for taking climate risk. It is therefore possible to be more selective around directing investments to companies who can make a real world difference, without sacrificing the ability to generate attractive yields and income for clients. We believe that implementing a forward looking, climate focused approach can help clients achieve their net zero and sustainability ambitions alongside their financial goals whilst contributing towards the crucial goal of transitioning to a net zero economy.
Implementing a climate transition approach in fixed income
The latest State of the Global Climate report for 2023 from the World Meteorological Organization (WMO) highlighted that global records were once again broken for greenhouse gas levels, sea level rise and glacier retreat amongst many others. Extreme weather and climate events caused turmoil across all continents in 2023, with life changing consequences for millions, and billions of economic losses incurred. The climate crisis is urgent, action is needed.
Real world records, real world problems
Sovereigns, corporates and asset owners are setting and working towards ambitious Net Zero targets that aim to limit global warming to 1.5 °C through climate policies and innovation with many of them typically aiming to reach net zero GHG emissions around 2050. Achieving this requires ambitious transition across all sectors of the economy which presents potential risks regarding the impact on companies arising from related market and policy changes, and the future value of assets. It can also uncover compelling investment opportunities aligned with a sustainable future. As the market for sustainable and climate themed solution evolves, new approaches continue to emerge. Here, we look at several key elements that we believe are important to consider when integrating a climate focused approach in fixed income portfolios.
For many, a common approach to building climate focused portfolios has been to avoid the highest emitting sectors or companies. Indeed, many climate or Paris aligned benchmarks or associated index-based solutions, have been structured around an exclusionary approach aiming to build climate funds that deliver a low-carbon footprint. However, simply avoiding can mean missing compelling opportunities. Take the utilities sector as an example.. Under an exclusionary approach, some investors might overlook certain utilities companies, including those with revenue contribution from fossil fuel power generation. Yet, that same company may be a leader in renewable energy, with plans to phase out fossil fuel driven energy. Avoiding such companies could forego the chance to invest in a company which is taking practical action to adapt their business and drive real world change. Portfolio managers can also utilise carbon budgeting techniques to optimise carbon intensity. Using negative and positive criteria, this can be useful for some clients seeking to manage their carbon footprint while retaining a focus on the portfolio’s financial goals. One challenge of these approaches is the heavy reliance on carbon data. Whilst the gap between equity and fixed income ESG and climate data has been closing, much of the data available is backward looking and therefore not reflective of a company’s future carbon emission reduction plans. Whilst such approaches can help decarbonise portfolios, they do very little to decarbonise the economy.
Transitioning to a net zero economy – risks and opportunities
How can fixed income investors navigate the complexities of climate transition? Can bondholders really make a difference to this real world issue?
Avoid?
Another route is to focus investments in businesses who are leading the way in ‘greener’ climate products, solutions and technology. Whilst this can often be a more common approach in equity or real assets, the universe of those companies issuing in bond markets is more restrictive. Given the importance of managing downside risk and the need for diversification in bond portfolios, the opportunity set for those type of strategies is still relatively limited. Within fixed income, understanding the potential risks to the sustainability of future cash flows is vital to retain the attractive, yet defensive, qualities that clients often seek. Understanding and actively managing climate related risks, should therefore be important in decision making for bond investors. As a source of finance for companies as they adapt their businesses to a net zero economy, we believe bondholders also have a role to play in helping fund the transition. We believe the greatest difference can be made by directing investments towards companies with robust and credible transition plans. Our proprietary climate transition framework takes a forward-looking view of issuers’ alignment toward net zero and identifies companies who are more likely to decarbonise in the future, which increases the potential for real world emissions reductions Rather than avoid the highest emitting sectors, we focus our research deep-dive on companies in high influence sectors, those that we deem to have a stronger ability to influence the energy transition and the achievement of global climate goals. As well as sectors like energy and real estate, we include banks and insurance companies in this group due to their ability to direct capital and potentially influence corporate behaviour through capital lending. Analysing the key climate issues for each sector, whether that relates to their direct operational emissions or emissions from products or supply chain, a qualitative assessment combined with meaningful data can help categorise companies’ transition readiness. This can also provide guide rails to construct portfolios that set milestones to adapt exposures to transition ready companies over time building a pathway to net zero.
Invest?
The engagement aspect of a climate approach is crucial. Whilst bondholders do not have the economic ownership or voting rights of a shareholder, engagement is no longer the sole preserve of equities and bond investors have levers to pull, both individually and collectively. Efforts focus on companies within high influence sectors with less developed plans. Engagement objectives seek to influence a company's behaviour including setting net zero goals and interim targets, improving disclosure, directing capex towards greener solutions and integration with strategic plans. The ability to engage and monitor progress towards specific objectives to help companies move forward should be an important component of any active climate approach.
Engage
“Many climate or Paris aligned benchmarks or associated index-based solutions, have been structured around an exclusionary approach aiming to build climate funds that deliver a low-carbon footprint”
“Investors are not paid a premium yet for taking climate risk. It is therefore possible to be more selective around directing investments to companies who can make a real world difference, without sacrificing the ability to generate attractive yields and income for clients”
Rory Sandilands, investment manager
Jill Shaw, senior investment product specialist
Important information For Professional Clients only and not to be distributed to or relied upon by retail clients. Past performance is not a guide to future performance. Opinions and examples represent our understanding of markets: they are not investment recommendations advice. All data is sourced to Aegon Asset Management UK plc unless otherwise stated. The document is accurate at the time of writing but is subject to change without notice. Data attributed to a third party is proprietary to that third party and is used by Aegon Asset Management under licence. Aegon Asset Management UK plc is authorised and regulated by the Financial Conduct Authority. Adtrax 6523588.7; Expiry 30 June 2025
“For fixed income investors, the talk of rate cuts as opposed to rate hikes is the most important factor, and that gives us a strong backstop for future returns”
“The soft-landing scenario is also starting to come more into focus in the US”
Inflation – finally on the right path?
So far this year we have been on more of a soft-landing trajectory. Business confidence remains low on both sides of the Atlantic at levels usually seen in recessionary or crisis periods. Unemployment is starting to tick up, albeit from a low base. The impact of higher interest rates is starting to be seen on household demand and spending, and whilst higher rates continue to be in place, we continue to see industrial operating pressure slowly increasing. This is true in the UK and Europe and whilst US growth looked more robust earlier in 2024, growth has been starting to moderate as evidenced in the Institute for Supply Management (ISM) May 2024 survey, where only one in the last twenty readings since Sept 2022 has been above 50, the level typically viewed as indicative of an expanding economy. So, the soft-landing scenario is also starting to come more into focus in the US.
Growth – Cooling, but not collapsing
A common theme this year has been transatlantic inflation divergence, with inflation surprising to the downside in Europe and in the UK, whilst for some time US inflation remained more persistent. However, more recently both CPI and the Fed’s preferred inflation measure of core PCE has been moving gradually lower and the latest June print showed a steady cooling in inflation. In the UK, the conversation has centered on the underlying components of inflation. Whilst we have seen headline UK inflation finally fall below the Bank of England's (BoE) 2% target level, having tipped over 11% in October 2022, services inflation has surprised to the upside and remains a key metric in the BoE’s next rate cut decisions. The look-through to services inflation is an important measure of underlying inflation in the real economy and is at the heart of whether the central bank believes that inflation can be sustained at this lower level. So, while it is welcome news that inflation has been tamed, we will have to wait until at least the August meeting for the BoE to be comfortable enough to reduce interest rates accordingly.
So far in 2024, bond markets have been driven from the top-down, with inflation continuing to be a key area of focus. Inflation surprises have been amongst the biggest stories so far this year, and this has in turn delayed the interest rate cycle. Rewind six months and many bond investors believed that, by now, most of the major central banks would have started a deep interest rate cutting cycle. As we approach the mid-year point, we have seen central banks in some smaller economies cut rates but amongst major markets we have only had one rate cut from the ECB. So, what will the macroeconomic picture look like for the remainder of 2024, and is it still supportive for bonds?
In terms of official interest rates, the key decisions now are whether to keep rates on hold or to cut. The ECB has already cut rates alongside the Bank of Canada, the Riksbank and Swiss National Bank, and we believe other central banks will follow suit with monetary policy at restrictive levels. We believe the Bank of England will be next to cut rates, with the Fed to follow. We believe September 2024 will be the start of the Fed’s rate cutting cycle, which will give them 3 more data points for payroll and inflation to monitor how cooperative the data will be. Of course, we still have the complication of upcoming elections and the potential for fiscal policy changes, so the respective central banks need to be confident that the data is going to require rates to be lowered. For fixed income investors, the talk of rate cuts as opposed to rate hikes is the most important factor, and that gives us a strong backstop for future returns.
Interest rates – are cuts still on the cards for 2024?
The path of inflation now looks more manageable. There are growth headwinds from rising unemployment and the impact of higher mortgage rates, and cracks are appearing in certain parts of economies. However, supportive fiscal policy has reduced near-term recession risks. The economic picture is not collapsing, but neither is it supportive of a meaningful acceleration Going into the second half of 2024, we continue to see a soft-landing scenario as the most likely to play out, which continues to support fixed income markets. Whilst we have had to wait longer for rate cuts than the market expected in the new year, the direction of travel is generally positive and the decline in inflation is giving bond markets some confidence and offering support to the outlook for government bonds and therefore broader fixed income market returns for the second half of 2024. However, with data surprises, election uncertainty and rising military tensions there is even more need for a flexible approach to take advantage of anomalies that arise as macroeconomic data evolves, and market valuations change. In the ever-changing macro backdrop, it is important to cut through the noise to position portfolios with a longer-term view of value in fixed income markets. Whilst we have seen a decoupling of credit spreads and rates year to date, with credit spreads performing strongly, yields across fixed income assets remain elevated and continue to offer investors an attractive opportunity to increase their fixed income allocation.
Looking ahead
Find out more about the Artemis Fixed Income Fund range
“Adding specific risk can mean that you don’t have to take as much outright duration or beta risk in portfolios to achieve the returns you’re looking for”
Identifying the right bonds can deliver superior returns without adding volatility
Returns since 1 November 2023 -%
Source: Bloomberg
Miller Homes 2009
10-year Gilt
High-yield bonds (£)
Adding generic credit risk can enhance returns
Investment-grade corporate bonds (£)
Return since 1 November 2023 -%
30-year Gilt
Adding duration increases returns but increases volatility
The most obvious way to profit from a fall in UK interest rates would have been to buy a government bond such as a 10-year Gilt. Typically, a 10-year Gilt has around 6.7-7 years of duration. Over the last six months, you’d have enjoyed a return of 5.4% from owning a 10-year Gilt. That’s a useful return from a high-quality asset, but it has come with significant volatility.
1. Adding duration
There is, however, another driver of returns that is often overlooked: adding ‘specific risk’ via stock selection. Using detailed credit analysis to identify the most attractive assets in each pocket of the bond market can dramatically enhance the returns from making the right calls on duration and credit beta. Adding specific risk can mean that you don’t have to take as much outright duration or beta risk in portfolios to achieve the returns you’re looking for. Let’s look at a worked example. Assuming that, last November, you shared our belief that rate cuts were coming, how would you have looked to reflect that view in your portfolio?
If you had been supremely confident that rate cuts were coming and you wanted to maximise your return, you might have added more duration by buying a 30-year Gilt, which runs with just over 16 years of duration. That would dramatically increase the interest-rate risk in your portfolio. Although adding that directional exposure would have increased your returns to 7.6%, it would have come at the cost of significantly greater volatility.
Adding generic long-dated investment-grade corporate bonds would have worked well, delivering a return of around 11%. But it would have come at the cost of a notable degree of volatility due to the increased risk taken. Alternatively, had you wanted to express a stronger view on the prosect for economically sensitive risk assets, you might have chosen to allocate to sterling-denominated high-yield bonds. (The higher yield and shorter maturity profile of the high-yield market means it carries less duration risk but more credit risk.) The return here would have been lower than from longer-duration strategies, but it would have been delivered with significantly less volatility.
Making the right calls on duration risk and credit risk clearly matters. But careful credit analysis has the potential to dramatically enhance the returns from getting those calls right. To take one example, there was a huge degree of negativity towards UK’s housebuilders towards the end of last year. Higher mortgage rates had put house prices under pressure. But the prospect of rate cuts in 2024 had the potential to catalyse a shift in sentiment towards the sector. In that instance, it might have been reasonable for you to add Miller Homes’ 2029 bonds to your portfolio. These are ‘split-rated’, falling somewhere between a ‘BB’ and ‘B’ rating; they are not towards the high-risk end of the high-yield market. So, the risk of default is fairly low, and they also carry a fairly low degree of duration. Returns from owning this bond over the last six months have been impressive. The returns here came from duration and credit beta (as with the first two examples) but were enhanced by a number of specific risks. Most obviously, Miller’s earnings appeared particularly well positioned to benefit from lower mortgage rates and stronger housing demand in the UK. In addition, negative sentiment towards the UK economy (in general) and rate-sensitive sectors such as housing (in particular) gave the bond significant valuation support from which to rally.
3. Adding ‘specific risk’: focus on credit selection
What other strategies might you have followed? You might have chosen to make an asset allocation call by adding some credit risk to your portfolio.
2. Adding credit beta
• •
Add ‘duration risk’ – make your portfolio more sensitive to a fall in interest rates, giving it directional exposure to lower bond yields. Add ‘beta risk’ – add generic credit risk by buying investment-grade or high-yield corporate bonds. In return for taking on a degree of directional credit risk, you’ll get an enhanced yield.
A proverb suggests that “there’s more than one way to skin a cat.” I’ve never wanted to put that to the test, so I don’t know if it’s true. But the point conveyed by this grisly image – that there’s more than one way of achieving any goal – certainly applies to investing in bonds. If you’re positive on prospects for the bond market (as we are) there are a number of ways you can express that view. You can, for example:
My point here isn’t about Miller Homes but about the incredible opportunities available to stockpickers. Within each pocket of the bond market, we would argue that it is possible to find specific assets with superior risk/reward characteristics. (My experience in running Artemis’ dedicated high-yield strategies and the high-yield element of the Artemis Strategic Bond Fund suggests those opportunities are particularly apparent in the high-yield market.) If they have the expertise to find them, investors have the opportunity to generate excess returns without taking outsized directional risks on duration or credit beta. Duration and asset allocation still matter – but they are not the be-all and end-all. What’s bad news for felines is good news for (active) bond investors: there’s more than one way to skin a cat.
“Because yields today are much more attractive, you don’t need to take outsized risks on duration to derive handsome total returns from your fixed-income allocation”
Liam O’Donnell, co-manager of the Artemis Strategic Bond Fund
Debt as % of GDP has surged
Source: Bloomberg, IMF, OBR
United Kingdom
United States
Dynamically managing duration amid volatility
Source: Artemis, Bloomberg.
10Y Gilt Yield
SBF Duration
10Y Treasury Yield
As yields fell, we reduced duration
We increased duration again as yields rose...
Source: Artemis
We have increased the duration of the Artremis Strategic Bond Fund up to a 6 ~ 6.5-year range
• • • •
If you believe – as we do – that interest rates are heading lower, then your recent conversations about bonds have probably touched on the question of duration. How much interest-rate risk should you be taking in your bond portfolio? With rates set to move lower, adding some duration might seem like a good idea. But can you go too far? Can you have too much of a good thing? I believe you can. To be clear, this is a good time to take duration risk. Over the last 12 months, we have taken the duration of the Artemis Strategic Bond Fund up to a 6-6.5-year range, which is above its long-term average. But at the same time, we haven’t pushed its duration to the maximum that our mandate – or our risk team – will allow.
There’s been a huge amount of volatility in the government bond market over the last six months. We don’t think that is an aberration. Compared to the disinflationary period between the financial crisis and the pandemic, when policymakers worried about deflation and bond markets were sedated by increasingly large doses of QE, the new era for bond markets seems likely to be characterised by:
The net result seems likely to be higher volatility. That, in turn, suggests that this is the time to think tactically and to act opportunistically. Bond managers can add real value by adding and subtracting duration as sentiment shifts and valuations move. This has been the approach we’ve taken in the Artemis Strategic Bond Fund.
Greater uncertainty about inflation. Desynchronization (in both economic and monetary policy terms) between different regions of the global economy. Political populism, fuelling worries about deficits. Quantitative tightening and the retreat of central banks from government bond markets.
1. Investors can generate returns through active, tactical duration positioning
These are not the conditions in which to take inflexible, extreme positions nor to go ‘all in’ on duration. Why not?
Whenever yields have rallied (as we saw in the final week of 2023) we have tended to take profits and sold duration. And whenever rates markets have taken fright from signs of ‘stickiness’ in inflation prints, we’ve added duration back again.
Debt-to-GDP levels worldwide have rocketed, particularly in the US, where the cost of servicing the federal debt is set to exceed military spending. Huge volumes of issuance will be needed to fund those deficits. There are already signs that the market is struggling to digest the volume of new issuance; some recent US Treasury auctions met with tepid demand . The coming wave of supply would suggest that a degree of caution towards the long end of the curve (which is where you need to hunt if you want to make an aggressive call on duration) might be wise.
Our strategic view is clear: yields are going lower from here. But at the same time, we're not going back to pre-pandemic conditions, when price-insensitive buying by central banks drove yields down across the curve and held them there. In the QE era, taking on lots of duration risk – and sticking with it – was a pretty effective strategy. But conditions have changed:
2. The long end of the curve may come under pressure
So, this isn’t the time to be dogmatic and it isn’t the time to take extreme position and simply stick with it. A different approach is needed…
Using active asset allocation to add or subtract credit risk and cyclicality by buying (or selling) investment-grade or high-yield corporate bonds. Using detailed credit analysis to identify the most attractive assets within each pocket of the bond market. This can dramatically enhance the returns you’ll see from making the right calls on duration.
Because yields today are much more attractive, you don’t need to take outsized risks on duration to derive handsome total returns from your fixed-income allocation. Today, two-year US Treasury yields are just under 5%. At more 4.4%, yields on two-year Gilts look healthy too . That is a great position to be in when inflation is falling and when central banks are preparing to cut rates. As Artemis’ rates specialist, it’s part of my job to ensure we get our calls on duration right. And, in broad terms, I am positive about duration. But at the same time, I don’t want to take an outsized view that would swamp every other potential source of return in our portfolio. We don’t think investors want strategic bond funds to be one-trick ponies. There are ways to enhance returns from your bond allocation other than simply adding duration risk, such as:
In a world where attention spans grow increasingly short, answering a question with the words "it's complicated" is a sure-fire way to be ignored. But if you ask me how much duration is too much, that’s the only honest answer I can give you. Complexity is unavoidable when one considers the structural shifts taking in a post-QE regime – and we think it should be embraced. A flexible approach is the most suitable one for the path that lies ahead.
3. There are other ways to generate returns
Sources 1. Treasuries Hold Day’s Losses as US Auction Met With Tepid Demand - Bloomberg 2. Artemis/LSEG as at 31 May 2024.
Find out more about the Artemis Strategic Bond Fund
Important information FOR PROFESSIONAL INVESTORS AND/OR QUALIFIED INVESTORS AND/OR FINANCIAL INTERMEDIARIES ONLY. NOT FOR USE WITH OR BY PRIVATE INVESTORS. This is a marketing communication. Before making any final investment decisions, and to understand the investment risks involved, refer to the fund prospectus, available in English, and KIID/KID, available in English and in your local language depending on local country registration, from www.artemisfunds.com or www.fundinfo.com. CAPITAL AT RISK. All financial investments involve taking risk and the value of your investment may go down as well as up. This means your investment is not guaranteed and you may not get back as much as you put in. Any income from the investment is also likely to vary and cannot be guaranteed. Market volatility risk: The value of the fund and any income from it can fall or rise because of movements in stockmarkets, currencies and interest rates, each of which can move irrationally and be affected unpredictably by diverse factors, including political and economic events. Investment in a fund concerns the acquisition of units/shares in the fund and not in the underlying assets of the fund. Reference to specific shares or companies should not be taken as advice or a recommendation to invest in them. Past performance is not a guide to the future. For information on sustainability-related aspects of a fund, visit www.artemisfunds.com. The fund is a sub-fund of Artemis Funds (Lux). For further information, visit www.artemisfunds.com/sicav. For changes made to the Artemis Funds (Lux) range of Luxembourg-registered funds since launch, visit www.artemisfunds.com/historic-changes. Third parties (including FTSE and MSCI) whose data may be included in this document do not accept any liability for errors or omissions. For information, visit www.artemisfunds.com/third-party-data. Any research and analysis in this communication has been obtained by Artemis for its own use. Although this communication is based on sources of information that Artemis believes to be reliable, no guarantee is given as to its accuracy or completeness. Any forward-looking statements are based on Artemis’ current expectations and projections and are subject to change without notice. Issued by: Artemis Investment Management LLP which is authorised and regulated by the UK Financial Conduct Authority.
“There is a common thread running through what generates outperformance – looking at things a little differently and finding opportunities in areas where others simply do not bother to look”
“The number of bonds available below ‘par’ – and therefore with capital upside to an early redemption – has never been as high as today, outside of periods of extreme stress”
Sources 1. Bloomberg, Bank of America, Artemis, ICE Fixed Income Indices (US High Yield 1-3yr index) as at 19 February 2024. 2. ICE BofA indices as at 31 March 2024. 3. Bloomberg/Lipper to 30 April 2024. 4. ICE BofA indices
There are two elements here. The first is the abstract idea that a single measure of high yield ‘spread’ is representative of thousands of underlying instruments. Are we referring to Isabel Marant Group 8% 2028 notes with a spread of 1,462bps as being tight? Or maybe Drax 6.625% 2025 notes with a spread of 0bps? We do not own the index (just a few percent of it) and therefore the average is a meaningless concept to us. The second is that spreads in high-yield bonds are not comparable to those in other fixed income markets. Unlike with government or investment grade bonds, for example, high-yield bonds have different potential redemption dates, and the timing of these – and the cash price paid – can have an enormous impact on spreads.
2. Risk-free rates are more attractive
1. High-yield spreads are too tight
Why would an investor want to buy high-yield bonds now? Spreads look tight, risk-free rates already offer mid-single digit returns, tight monetary policy leads to investors taking risk off the table and equities look like they will offer better returns. So high yield seems like an obvious part of the market to avoid, right? We disagree. Let’s go through each of the four statements above to explain why.
As an example, we own Penske Automotive Group September 2025 notes. These bonds currently trade at a spread to worst (the figure used in index ‘spread’ numbers) of 92bps over Treasuries. Now, it is a BB (meaning it is towards the higher quality end of the high-yield spectrum) with a $10 billion market cap, estimated to generate $900m of free cashflow this year, and the $550m 2025 bond is the first debt maturity, so that stated 92bps yield pickup over a 2025 Treasury looks fair. However, these bonds are unlikely to see September 2025. Over the past year, the average high-yield bond has been redeemed 15 months before maturity . If we assume Penske’s bonds get redeemed 12 months early, the spread over Treasuries jumps to 850bps. That’s quite a difference from 92bps. The number of bonds available below ‘par’ – and therefore with capital upside to an early redemption – has never been as high as today, outside of periods of extreme stress . And that neatly illustrates why the index spread levels for shorter-dated high-yield bonds are largely irrelevant in today’s market.
It is true that risk-free rates look attractive today. The issue is that as time goes on, the opportunity cost from sitting in cash and cash equivalents rather than higher-yielding parts of the market compounds. Let’s take an investor who bought US T-bills (short-dated US government bonds) the moment they passed a 3% yield (30 September 2022) and held them through to today. They would have made a total return of 7.8% over this time. Not too shabby. But over the same period, our Artemis Funds (Lux) – Global High Yield Bond Fund delivered a total return of 19.3% . The missed carry from high-yield relative to risk-free rates over the period means that even if there were a significant market downturn from here, the investor who remained in cash the whole time would likely still end up worse off versus the one who remained in high-yield bonds.
While tight monetary policy does cause investors to sell riskier assets, high-yield bonds tend to do well in these periods. Since the beginning of the 1980s, there have been eight hiking cycles that ended in cutting cycles. The average one-year total return on US high yield from the time of the first cut has been +7.1% . Put simply, the end of a hiking cycle (in other words, the start of a cutting cycle) tends to be good, not bad, for high yield.
3. Tight monetary policy leads to a risk-off environment
Equities have had a great run of late. And as our head of fixed income Stephen Snowden likes to say, everyone should buy equity funds. However, with yield levels where they are today, returns from our area of the market have historically been comparable to those from equities. The US high-yield market currently yields 8.2%. Based on the US high-yield index and the MSCI World index, when yields exceed 8%, the average three-year annualised return on high yield has been 2.6 percentage points above that seen on equities. I do not want to leave anyone thinking they should not own equities – they should – but high yield at these valuations offers a very nice complement to other portfolio assets from both a return, and a risk, perspective.
4. Equities offer more attractive returns
There is a common thread running through what generates outperformance – looking at things a little differently and finding opportunities in areas where others simply do not bother to look. The high-yield market offers a huge opportunity for investors who are willing to do just this. Ultimately, I think the question is not why should you own high-yield bonds at this point, but more why wouldn’t you?
Opportunity
Jack Holmes runs through some of the biggest misconceptions about the high-yield bond market
Important information This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates rise and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Due to the greater possibility of default, an investment in a corporate bond is generally less secure than an investment in government bonds. Fidelity’s range of fixed income funds can use financial derivative instruments for investment purposes, which may expose them to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Reference to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes. Investments should be made on the basis of the current prospectus, which is available along with the Key Investor Information Document (Key Information Document for Investment Trusts), current annual and semi-annual reports free of charge on request by calling 0800 368 1732. Issued by FIL Pensions Management, authorised and regulated by the Financial Conduct Authority. Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. FIPM: 8217
Discover Fidelity's Sterling Investment Grade Credit fund range
As shown below, the wipeout yield for 1-5yr Corporate Bonds is currently 1.9%, meaning that yields would need to rise by 1.9% to lose one year’s worth of carry. The wipeout yield for 1-5yr Corporate Bonds compares favourably to All-Maturity Corporate Bonds and All-Maturity Gilts, at 0.9% and 0.4% respectively. This is an attractive risk-adjusted option for investors seeking investment grade exposure but concerned about interest rate volatility.
Within the credit universe, the front-end offers the most value
Given that investment grade credit is traded on spread, we can also look at wipeout spreads to get a more tangible understanding of the breakeven point from a credit spread perspective. Wipeout spread measures the spread move required to ‘wipeout’ a year’s worth of spread carry. Similar to wipeout yields, there is a clear inversion pattern with the front-end offering the most value. We have picked out two bonds from the sterling IG universe to illustrate our point. Wellcome Trust (WELLTR) is a high-quality triple-A rated issuer that operates as a non-profit organisation offering medical and health facilities to communities in the UK. The curve is inverted with the 2059 maturity bond trading 18bps tighter than the 2036 maturity bond. As of March 2024, the credit spread for the 2059 bond was 15bps and the spread duration was 17.8yrs, indicating a wipeout spread of just under 1bp.
This implies that if spreads were to widen just 1bp, that would wipeout one year of spread carry. The 2059s have widened +14bps since the end of March with the spread to benchmark currently at 29bps, indicating that more than fourteen years of carry have already been wiped out! Moreover, the current bid-ask spread is 6bps which is around 7x the wipeout spread for the bond. We see little value in owning these types of bonds at this point in the cycle, hence our underweight position. This is not an isolated occurrence and there are numerous other long-end bonds with similar characteristics. In comparison, Westfield Stratford (WSTSTR) is an A+ rated bond secured on the Stratford shopping centre. As of March 2024, the credit spread for the 2026 WSTSTR bond was 197bps and the spread duration was 2.3yrs, indicating a wipeout spread of 86bps. This implies that it would take 84bps of spread widening to wipe out one year of spread carry. Again, to give context, this is 5bps more than the spread widening we saw during the COVID sell-off when all shopping centres were closed indefinitely. We can hence conclude that it would take an extreme event for bondholders not to do better than gilts. This bond, therefore, offers an appealing risk-adjusted return which we have reflected through our overweight position in the bond across our Short Dated Corporate Bond, Sustainable Moneybuilder Income and Sterling Corporate Bond Funds.
As expected, sterling high yield offers the highest wipeout yield (high yield and low duration), but this involves greater credit risk and a higher beta to negative risk events. To put these figures into context, during the worst risk off event in the last decade, the COVID sell-off in March 2020, short dated investment grade credit widened by 1.1%. During the same period, high yield credit widened by 5.5%, 5x the beta of investment grade. Given our current position in the economic cycle, where spreads are already very compressed and the double-B to triple-B spread is very low, we think that it makes sense to start switching from high yield into investment grade.
A tale of two stories…
Over the past few years, wipeout yields have risen considerably with the front-end (sub-5yr duration bonds) now looking notably more attractive. Below we look at every bond in the sterling investment grade credit market and measure their wipeout yield in Q3 2021 vs Q1 2024. In Q3 2021, wipeout yields were 0.2% across the market as a whole, with few bonds offering a wipeout yield greater than 1%, meaning that if yields were to increase by just 0.2%, the market would be expected to return nothing. Between Q3 2021 and Q3 2022, 10yr yields rose a record-breaking 3.5% as the BoE started to hike interest rates. With a breakeven rate of just 0.2%, this explains why returns were so poor during the period; a low starting yield coupled with a huge rise in rates.
We are now in a completely different market, with front-end credit offering wipeout yields anywhere between 1% to 8% and on average, 1.9%. We do not anticipate that yields will rise by more than 1.9% in one year and thus expect that investors could generate positive returns by investing in the front-end. Given current yields, it is very unlikely that we will have a repeat of 2022. Between September 2021 and September 2022, yields rose 3.5% which wiped out the equivalent to 10.5yrs worth of carry. In comparison, if yields were to rise 3.5% now, it would take less than 2yrs to make back the lost carry.
Wipeout yields have risen over the past few years
Wipeout yields, also known as breakeven rates, are calculated as the yield-to-maturity divided by interest rate duration. They are expressed as the increase in yields required to “wipeout” one year of carry and so the larger they are, the greater the buffer against increased yield volatility or further yield rises. Short dated credit tends to have a high wipeout yield due to its combination of attractive yield levels and low duration (high numerator, small denominator).
What are wipeout yields?
For the last six months, we have gradually been reducing spread duration and upping the credit quality in our funds through shortening trades (adding 0-5yr maturity sterling credit). We are implementing these trades because they allow us to pick-up yield whilst reducing credit risk due to the combination of inverted yield curves and flat credit curves. Short-dated credit currently looks appealing for a number of reasons but given the growing uncertainty surrounding the timing of the Bank of England (BoE) interest rate cuts, we are particularly focussed on the attractive wipeout yields available in front end-credit.
Source: Bloomberg, March 2024. Figures are based on the ICE BofA Indices: BofA UK Gilt Index (G0L0), BofA 1-5 Year Eurosterling Index (EVL0), BofA Euro-Sterling Index (E0L0), BofA 10+ Year Eurosterling Index (E9L0) and BofA Sterling High Yield Index (HL00) as above.
Wipeout Yields
2.4
1.8
1.2
Gilts (G0L0)
1-5YR (ELV0)
All-Maturity (E0L0)
10YR+ (E9L0)
Sterling HY (HL00)
Wipeout yields comparison across the credit spectrum
Sep - 21
Mar - 24
Wipeout yields have increased dramatically since the BoE rate hikes
Source: Bloomberg, March 2024. Displays all the bonds in the ICE BofA Euro-Sterling Index (E0L0) at the time.
7%
5%
3%
1%
Wipeout Yield
Duration
Wipeout yields in Q3 2021
Wipeout yields in Q1 2024
WSTSTR 1.642% 08/04/26 (owned in our fund)
WELLTR 4% 05/09/59
“Wipeout spread measures the spread move required to ‘wipeout’ a year’s worth of spread carry. Similar to wipeout yields, there is a clear inversion pattern with the front-end offering the most value”
“Short-dated credit currently looks appealing for a number of reasons but given the growing uncertainty surrounding the timing of the BoE interest rate cuts, we are particularly focussed on the attractive wipeout yields available in front end-credit”
Xxxxxxxxxxxxxxx
Ian Fishwick, fund manager
Important information This is for investment professionals only and should not be relied upon by private investors. The value of investments and the income from them can go down as well as up so you may get back less than you invest. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes. The value of investments in overseas markets may be affected by changes in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. Rising interest rates may cause the value of your investment to fall. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Sub-investment grade bonds are considered riskier bonds. They have an increased risk of default which could affect both income and the capital value of the fund investing in them. They can also use financial derivative instruments for investment purposes, which may expose the funds to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Investments should be made on the basis of the current prospectus, which is available along with the Key Investor Information Document (Key Information Document for Investment Trusts), current annual and semi-annual reports free of charge on request by calling 0800 368 1732. Issued by FIL Pensions Management, authorised and regulated by the Financial Conduct Authority. Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. FIPM: 8217
Important information This information is for investment professionals only and should not be relied upon by private investors. The value of investments and the income from them can go down as well as up so the client may get back less than they invest. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates rise and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Due to the greater possibility of default, an investment in a corporate bond is generally less secure than an investment in government bonds. Fidelity’s range of fixed income funds can use financial derivative instruments for investment purposes, which may expose them to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Investments should be made on the basis of the current prospectus, which is available along with the Key Investor Information Document (Key Information Document for Investment Trusts), current annual and semi-annual reports free of charge on request by calling 0800 368 1732. Issued by FIL Pensions Management, authorised and regulated by the Financial Conduct Authority. Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM0524/386798/SSO/NA
Discover the Fidelity Short Dated Corporate Bond Fund
Fidelity Short Dated Corporate Bond Fund
ICE BofA 1-5yr Euro Sterling Index
Markit iBoxx GBP Corporates 1-5 Index
Legal & General Short Dated Sterling Corporate Bond Index Fund
Vanguard U.K. Short-Term Investment Grade Bond Index Fund
Bloomberg GBP Non-Government 1-5 Year 200MM Float Adjusted Bond Index
ASI Short Dated Sterling Corporate Bond Tracker Fund
Markit iBoxx Sterling Non-Gilts (1-5 Year)
Calendar year return tables
Source: Fidelity International, Bloomberg, competitor websites, 2024. All data is net of fees.
Despite this backdrop, we strongly believe that going passive in the short dated space is sub optimal, and this goes beyond the typical arguments for going active over passive, which include, for example, picking the winners and avoiding the losers (this certainly also applies here). Our active approach specifically exploits the forced passive buying and selling at either end of the maturity spectrum. Below we delve into this in more detail, highlighting the benefits of going active over passive in the asset class and how we specifically exploit short dated passive funds to our benefit. As a general rule, passive funds underperform their indices on a net basis because of fees and transaction costs. We’d argue that this underperformance is more pronounced in the short dated space because the absolute level of return is more muted than in other parts of the maturity spectrum. To illustrate this, we have looked more closely at all three passive short dated funds in the IA Sterling Corporate Bond sector, with the longest running track record going back to 2014. Since inception, this passive fund has delivered an average calendar year underperformance of 0.2% versus its respective index. Considering the average calendar year return from the index was 1.5% over the period (2014 to 2023), a 0.2% underperformance is just over 10% of total return lost. While some investors look to go passive in the space because the return potential is lower, paradoxically, for that same reason, it may make sense to consider going active. We would argue that 0.2% in return in the short-dated space means more than 0.2% return in higher risk asset classes, such as equities or all-maturity bonds.
Most passive funds tend to underperform their indices by more than the fees charged which we believe is due to the additional costs arising from elevated trading, associated with trying to replicate a short-dated index. All three passive funds in the IA Sterling Corporate Bond sector aim to replicate a 1-5 year index. A 1-5 year index constantly has bonds entering the index as they move from six years to five years in maturity, and constantly has bonds falling out of the index as they move below one year in maturity. This will lead to elevated trading for the passive community aiming to replicate this exposure, as they may be forced to buy and sell respectively at either end of the maturity spectrum. To illustrate this, we compare the 1-5 year index we use for our Fidelity Short Dated Corporate Bond Fund with its all-maturity counterpart, to measure how many bonds would fall into the 1-5 year index (by moving from six years to five years maturity) and out from the 1-5 year index (by moving sub-one year maturity) over the following 12 months. Based on April 2024, 82 bonds would move from six years to below five years to maturity and enter the index while 152 bonds would move to sub-one year in maturity and fall out of the index, a total 234 bonds. The 1-5 year index contains 612 bonds in April 2024, suggesting over a third (38%) the number of bonds in the index would move in the space of 12 months! And this excludes the impact from potential new issues. This excessive and forced trading does not occur for all-maturity passive bond funds. It is notable that short dated passive funds tend to underperform their indices more (after fees) than their all-maturity counterparts, despite being offered by the same provider and therefore presumably using the same trading processes.
Passive is suboptimal in short dated corporate bonds
As active investors, we are happy to take out-of-index exposure across sub-one year bonds and up to six year maturity bonds. For example, we can buy a sterling investment grade bond with five and a half-years left to mature, knowing this is about to enter the 1-5 year index and therefore benefit from forced passive buying. At the other end of the maturity spectrum, we can buy bonds with sub-one year maturity to take advantage of forced passive selling. This paper has additional benefits and can prove to be an attractive hunting ground for active investors despite being so close to maturity. At the end of Q1 2024, 9.6% of the Fidelity Short Dated Corporate Bond Fund (all off-benchmark) matured in less than one year. Somewhat remarkably, the average yield to maturity on this sub-one year paper (5.12%) is greater than the yield on the index (5.0%), despite the lower interest rate risk associated with it. Part of this yield advantage is due to forced selling by passives due to their rules-based, rather than value-based, approach. Banks are also unwilling to expend a significant amount of their risk in such instruments, allowing us to take advantage of this technical backdrop. Sub-one year paper also acts as natural liquidity as the bonds mature generating cash for the portfolio. This has further benefits in a rising yield environment as we can then deploy the cash into higher yielding securities. Investors who use the fund as a cash diversifier often like this liquidity feature.
We also selectively invest in non-sterling short dated credit and have over 36% of the portfolio in non-UK names. US Dollar or Euro-denominated bonds issued by traditionally sterling-centric companies can serve as a useful hunting ground. If our credit analysts and traders based in North America or in Asia highlight a non-sterling issue as more attractive than an in-index sterling bond (after accounting for hedging costs back to Sterling), then we are happy to own. In addition, the non-sterling market can prove useful for diversification purposes, allowing us to add exposure that may feature rarely in the sterling credit, such as names in energy or healthcare.
Exploiting the passive community
The Fidelity Short Dated Corporate Bond Fund is primarily invested in high quality short dated corporate bonds and was launched just under seven years ago, employing a highly active approach. The Fund is managed within Fidelity’s highly experienced sterling investment grade portfolio management function, alongside our flagship Fidelity Sustainable MoneyBuilder Income Fund and Fidelity Sterling Corporate Bond Fund. The Fund has generated attractive excess returns over index (after fees) since inception and is one of Fidelity’s lowest volatility bond funds. Moreover, relative to the IA Sterling Corporate Bond Sector, the Fund is currently 1st quartile over 3 and 5 years, offers a 1st quartile yield, a 1st first quartile risk profile (in terms of 5 year volatility) and 1st quartile fees.
Time to consider an active fund?
When choosing short dated corporate bond funds, UK investors often look to passive vehicles, citing the lower return potential of the broader asset class. Just over a quarter of the all-maturity sterling corporate bond market is passive (£18.7bn out of £66.1bn) compared to 40% of the short-dated market (£4.5bn out of £11.3bn) as per figure 2 below. This may seem intuitive, as investors perceive there to be little absolute return or potential excess return on offer in relatively low risk short dated corporate bonds. Therefore, why pay up for active management?
In short-dated compared to all-maturity, passives represent a greater market share
Firstly, interest rate volatility has picked-up meaningfully as inflation has proven stickier than expected causing central banks to tighten monetary policy more than what markets anticipated, pushing yields higher. Large drawdowns in duration-heavy asset classes ensued and prompted investors to lower their interest rate volatility via shorter-dated bonds (which are less sensitive to interest rate risk). Secondly, while cash rates have become more attractive, for a little more risk, short-dated investment grade credit can offer a yield pick-up over cash and government bonds, helping investors to increasingly sweat the cash element of their portfolio. We are seeing interest from pension and company treasurers for short dated credit for their treasury money. Others are also increasingly turning to short dated credit as an allocation for the penultimate stages of their de-risking journey. Finally, the inversion of the yield curve, meaning yields on shorter-dated bonds are now higher than yields on longer-dated bonds, means more yield can be achieved for less duration risk, which offers investors an attractive risk-adjusted option.
Source: Fidelity International, Morningstar, 31 March 2024. Performance reflects Fidelity Short Dated Corporate Bond Fund W Income Shares, basis Bid-Bid with income reinvested in GBP. Comparative Index: ICE BofA 1-5 Year Eurosterling Index. Quartile stats based on Morningstar data in the IA Sterling Corporate Bond sector to 31 March 2024. Index stats based on the ICE BofA Euro Sterling index relative to the ICE BofA 1-5yr Eurosterling index, using data from March 2024.
YTD
1 Year
3 Year (ann.)
5 Year (ann.)
Since Inception (Ann.)
-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
Fund (Gross)
Fund (Net)
Index
1.0%
0.6%
7.4%
7.1%
5.8%
1.1%
0.8%
1.9%
1.6%
2.1%
1.8%
-0.3%
Figure 1: IA Sterling Corporate Bond sector, short-dated versus all-maturity
Source: Fidelity International, Morningstar, 12 April 2024. Data taken from funds in the IA Sterling Corporate Bond sector.
Active
Passive
Total
6,605
AUM (£m)
% of the market
Short Dated
All Maturity
Number of Funds
4,530
11,135
59%
41%
45,453
18,655
64,108
71%
29%
13
78
91
“Sub-one year paper acts as natural liquidity as the bonds mature generating cash for the portfolio. This has further benefits in a rising yield environment as we can then deploy the cash into higher yielding securities”
“We strongly believe that going passive in the short dated space is sub optimal, and this goes beyond the typical arguments for going active over passive, which include, for example, picking the winners and avoiding the losers”
High-quality short dated investment grade credit is increasingly being favoured by investors of all types - from individuals to investment professionals across wealth manager groups and pension schemes - for a variety of reasons
5 / 5
4 / 5
3 / 5
2 / 5
1 / 5
Ben Deane, Investment Director, Fixed Income
For Professional Investors only. All investments involve risk, including the possible loss of capital. In the United Kingdom, information is issued by PGIM Limited with registered office: Grand Buildings, 1-3 Strand, Trafalgar Square, London, WC2N 5HR. PGIM Limited is authorised and regulated by the Financial Conduct Authority (“FCA”) of the United Kingdom (Firm Reference Number 193418), and with respect to its Italian operations by the Consob and Bank of Italy. In the European Economic Area (“EEA”), information may be issued by PGIM Netherlands B.V., PGIM Limited or PGIM Luxembourg S.A. depending on the jurisdiction. PGIM Netherlands B.V., with registered office at Eduard van Beinumstraat 6 1077CZ, Amsterdam, The Netherlands, is authorised by the Autoriteit Financiële Markten (“AFM”) in the Netherlands (Registration number 15003620) and operates on the basis of a European passport FOR IMPORTANT INFORMATION RELATED TO RISKS AND DISCLOSURES PLEASE VISIT PGIM.COM/UCITS/DISCLOSURE. © 2024 Prudential Financial, Inc. (PFI) and its related entities. PFI of the United States is not affiliated with Prudential plc, incorporated in the United Kingdom or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom. PGIM and the PGIM logo are service marks of PFI and its related entities, registered in many jurisdictions worldwide. 3661664
“As long as the economy remains resilient, the market is willing to fund companies at fairly high coupons”
Jonathan Butler, portfolio manager, PGIM Global High Yield Bond Fund
“The quality of the market is higher than ever”
Driving Butler’s optimism is the current elevated yield environment and the U.S. Federal Reserve’s caution about cutting interest rates because inflation remains sticky. Bond yields peaked just above 8% in recent years when rates were rising. Historically, when starting yields fall in the 7-9% range, high yield fixed income has posted positive returns 86% of the time in the following year, with half of those periods generating double-digit gains. The global high yield bond market rose 13% in 2023, outperforming investment-grade bonds by 4%. Although spreads are currently tight in both markets, the high yield sector benefits from a yield advantage and is continuing to outperform the investment-grade sector in 2024.
Benefiting from historical yield trends
Along with the positive returns, PGIM Fixed Income’s high yield default outlook is muted because credit quality in the sector remains high. Defaults are expected to be contained at about 3.5% over the next 12 months, which is in line with the historical median level and far below the levels seen during the Global Financial Crisis of 2008-09 and the COVID-19 pandemic of 2020-21. Butler said companies are doing a good job maintaining their liquidity, with just as many receiving debt upgrades from credit rating agencies as downgrades even at this late stage in the current economic cycle. ‘The quality of the market is higher than ever,’ Butler said.
Expecting manageable defaults
While high yield issuers seeking to refinance debt now at elevated interest rates may face increased credit risk, strong corporate fundamentals should minimize that liability, Butler said. In fact, refinancing activity may be low this year because most of the outstanding high yield debt maturing in 2024 and 2025 has already been refinanced. Butler expects refinancing needs to peak in 2026 in Europe and in 2029 in the U.S. This activity should be manageable, he said, especially if private credit markets continue to offer a significant funding alternative. ‘As long as the economy remains resilient, the market is willing to fund companies at fairly high coupons,’ Butler said.
Minimising refinancing risk
After two years of uncertainty highlighted by rising inflation, aggressive interest rate hikes, and rate-cut expectations, PGIM Fixed Income’s Jonathan Butler, portfolio manager of the PGIM Global High Yield Bond Fund, views today’s environment as highly favourable for high yield bonds. Despite elevated inflation and potentially slow growth—a scenario that PGIM Fixed Income calls ‘weakflation’—the global economy remains resilient, a soft landing is still possible, and recession odds are receding. ‘Our two most likely scenarios, weakflation and a soft landing, provide an exceptional backdrop for high yield fixed income,’ Butler said.
Although the high yield bond outlook is bright, risks vary widely by credit rating, with significantly more risk and also potential reward available to investors in lower-rated debt. PGIM Fixed Income’s deeply experience high yield bond team can help investors navigate these complexities by performing diligent research from the bottom up to identify relative value opportunities. ‘The high yield asset class offers attributes that should appeal to the varied needs of investors across the globe,’ Butler said. ‘Active global strategies maintain the flexibility to capitalise on nuances that extend across regional markets.’
Navigating nuances with an experienced active manager
PGIM Fixed Income’s Jonathan Butler sees a sweet spot for high yield bonds in today’s economic environment and highlights the benefits of active management
For Professional Investors only. All investments involve risk, including the possible loss of capital. Risks: An investment in the Fund involve a high degree of risk, including the risk that the entire amount invested may be lost. The Fund are primarily designed to purchase certain investments, which will introduce significant risk to the Fund, including asset performance, price volatility, administrative risk and counterparty risk. No guarantee or representation is made that any fund’s investment program will be successful, or that such fund’s returns will exhibit low correlation with an investor’s traditional securities portfolio. In the United Kingdom, information is issued by PGIM Limited with registered office: Grand Buildings, 1-3 Strand, Trafalgar Square, London, WC2N 5HR. PGIM Limited is authorised and regulated by the Financial Conduct Authority (“FCA”) of the United Kingdom (Firm Reference Number 193418), and with respect to its Italian operations by the Consob and Bank of Italy. In the European Economic Area (“EEA”), information may be issued by PGIM Netherlands B.V., PGIM Limited or PGIM Luxembourg S.A. depending on the jurisdiction. PGIM Netherlands B.V., with registered office at Eduard van Beinumstraat 6 1077CZ, Amsterdam, The Netherlands, is authorised by the Autoriteit Financiële Markten (“AFM”) in the Netherlands (Registration number 15003620) and operates on the basis of a European passport. The Fund is a sub-fund of PGIM Funds plc. An investor must review the Fund’s prospectus, supplement and Key Investor Information Document (“KIID”) or Key Information Document (the “KID”), depending on the jurisdiction (together, the “Fund Documents”) before making a decision to invest. The Fund Documents are available at PGIM Limited, 1-3 The Strand, Grand Buildings, Trafalgar Square, London, WC2N 5HR, PGIM Netherlands B.V., Gustav Mahlerlaan 1212, 1081 LA, Amsterdam, and/or PGIM Luxembourg S.A., 2, boulevard de la Foire, L-1528 Luxembourg, or at www.pgimfunds.com. The information herein is for informational or educational purposes. The information is not intended as investment advice and is not a recommendation about managing or investing assets. In providing these materials, PGIM is not acting as your fiduciary. FOR IMPORTANT INFORMATION RELATED TO RISKS AND DISCLOSURES PLEASE VISIT PGIM.COM/UCITS/DISCLOSURE. © 2024 Prudential Financial, Inc. (PFI) and its related entities. PFI of the United States is not affiliated with Prudential plc, incorporated in the United Kingdom or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom. PGIM and the PGIM logo are service marks of PFI and its related entities, registered in many jurisdictions worldwide. 3673231
The PGIM Multi Asset Credit Fund was recognised for its excellence at the 2024 Fund Manager of the Year Awards, winning the Global Bonds category.
“Our sector specialists do the trading and buy the best ideas across the fixed income spectrum”
Gabriel Doz, portfolio specialist, PGIM Fixed Income
Two years ago, financial markets experienced the highest inflation in four decades followed by aggressive interest-rate hikes by the U.S. Federal Reserve and other central banks worldwide to tame it. Although inflation has cooled since then, these trends have fundamentally altered global credit markets, presenting fixed income investors with significant challenges but also creating generational opportunities for strategies like the PGIM Multi Asset Credit Fund. Investors in the Fund benefit from:
Capitalising on generational opportunities
Doz sees the Fund fitting strategically into an investor’s portfolio for several reasons:
Positioning portfolios with PGIM’s multi-asset credit strategy
In the view of PGIM Fixed Income’s Gabriel Doz, today’s market backdrop – solid growth in the 2% range and inflation converging toward the Fed’s 2% target – helps showcase the deep experience and nimble nature of the PGIM Multi Asset Credit Fund’s investment team. In this scenario, which PGIM Fixed Income has dubbed “moderation,” the Fund’s portfolio managers determine how much risk to take for the portfolio based on macroeconomic conditions and the firm’s overall risk appetite. Then they allocate across a broad range of fixed income sectors and regions, tapping the expertise of one of the world’s largest credit research teams. ‘Our sector specialists do the trading and buy the best ideas across the fixed income spectrum,’ said Doz, a PGIM Fixed Income portfolio specialist.
Resources and presence to source ideas globally: The team’s global presence provides a broad perspective of credit markets, and its expertise spans multiple strategies with a focus on asset allocation and integration of best investment ideas. Broadly diversified allocation across fixed income sectors, industries and issuers: The team nimbly extracts multiple sources of alpha through active allocations across spread sectors, with an emphasis on industry and issuer credit research. This collaborative, bottom-up, research-driven security selection process allows managers and analysts to make joint decisions. Emphasis on quantitative research and risk management: The team also focuses on proprietary quantitative analytics, risk management and performance attribution. It monitors active risk positions daily, incorporating quantitative modeling and risk management infrastructure together with proprietary tools that aid in alpha generation.
‘The Fund uses all the different resources that we have at PGIM Fixed Income, which has potentially the largest team of credit research analysts in the industry as well as a really well-resourced and experienced portfolio management team,’ Doz said.
Allows investors to ‘outsource’ credit decisions to a leading active fixed income manager, benefiting from the team’s sector allocation and security selection expertise Offers elevated yield for income-seeking investors Complements strategic bond funds offered by other managers
‘We’ve looked at correlations with our peers, and our Fund is actually a very nice complement to some of the other strategic bond funds that are out there,’ Doz said.
