Do bond markets face a perfect storm?
While rising inflation and growing volatility pose some risks to fixed income investors, the wider market dislocations they drive are exposing some attractive opportunities for active bond investors, says Insight Investment senior portfolio manager Adam Whiteley.
In a market already facing rising inflation, the Russia/Ukraine conflict has presented a worrying new geopolitical concern for global investors. Against this backdrop and a recent rise in bond market volatility, many fixed income investors have faced a bruising start to the year.
The Bloomberg Global Aggregate Index, a benchmark for corporate and government debt, fell 11% from a high in early 20211, one of the biggest falls from a peak in data since 1990, while Bloomberg data also showed the yield on the 10-year US Treasury note dipped below the yield on the two-year US Treasury on 29 March2. Although this dip was brief, these so-called yield curve inversions are often seen as a harbinger of recession, adding further gloom to some market outlooks.
Beyond this immediate storm, Insight Investment portfolio manager Adam Whiteley says policymakers also face some serious challenges, balancing negative real wage growth across markets such as the US – after adjusting for inflation – and renewed geopolitical unrest.
“Inflation is now accelerating to levels we have not seen for a long time,” he says. “This creates an environment where it becomes reasonable to expect further central bank policy rate increases. That could put upward pressure on government bond yields and therefore will likely squeeze some areas of fixed income.”
Yet behind the headlines Whiteley sees some more positive signs for active bond managers. Market dislocation, driven by rising volatility and wider uncertainty over central bank moves is, he contends, opening significant new pockets of opportunity for fixed income investors searching for value.
“The economic and policy uncertainty we face today are almost unprecedented,” he says. “The good news is that volatility is creating opportunities. It has thrown everything up in the air and opportunities are likely to fall across different areas, with active portfolio managers trying to interpret changing themes and pricing in the new information. In many ways volatility could be seen as a necessary ingredient for managers seeking to unearth opportunity and add value.”
Whiteley identifies, so-called rising stars – companies with ratings that get upgraded to investment grade from riskier high yield – as just one area of growing opportunity.
“Since the Autumn we have seen more upgrades to investment grade than we have downgrades into high yield and this shift is creating varied opportunities for investors in rising stars despite ongoing economic uncertainty,” he says.
Whiteley also expects to see healthy mergers and acquisition (M&A) activity continue in the months ahead, fuelling corporate issuance and creating further investment opportunities as the worst of the Covid-19 pandemic continues to fade.
“The current volume of pending M&A activity is at levels we have not seen over the last 10 or 20 years and we see no reason why that should ease off throughout this year,” he says.
“The bottom line is that all that M&A will need financing. Companies will come to bond markets to borrow to fund that activity. That gives active fund managers an opportunity to buy into what they hope will be a strong business story in the years that follow – hopefully with some associated deleveraging as companies pay down that acquisition debt.”
Whiteley adds that the latest M&A trend is not just prevalent in Europe but has also been evident for some time in the US.
“The US was arguably one of the first countries to show real signs of recovery from the Covid-19 pandemic and many of its businesses are beginning to feel confident about the future again. While the geopolitical risks we have seen rising over the last few weeks may begin to dent that corporate confidence we remain optimistic on the US outlook,” he concludes.
1 As at March 22. Source. Bloomberg. This is now the worst drawdown on record for global fixed income. 22 March 2022.
2 Yahoo Finance. Yield curve briefly inverted for first time since 2019. 29 March 2022.
936150 Exp: 06 September 2022