By Olivier Debat, Senior Fixed Income Specialist at UBP.
By any measure, fixed income had a tough 2022. Interest rates increased from both very low, and in some cases negative, levels, rising rapidly due to central banks’ actions to tame inflation, and credit spreads widened over fears of a deep recession. Notably though, the difficulties of 2022 have transitioned into the opportunities of 2023, particularly for higher-income fixed income strategies.
Indeed, the rate repricing has now largely occurred, with the Fed talking about incremental changes to monetary policy as opposed to more aggressive moves, coupled with a macroeconomic environment that looks to be of modest growth, potentially avoiding a recession on both sides of the Atlantic.
The yield offered on high-yield bonds has doubled since the lows of 2021 despite issuers’ fundamentals arguably improving. Metrics such as net leverage and interest coverage ratios are strong when compared to historical averages and although the fundamentals could of course deteriorate, the main takeaway is that the starting point is very healthy. As a consequence, although defaults may increase from their extremely low base, we do not expect the rise to be material and for those issuers that do run into difficulty, it will be linked to idiosyncratic stories rather than any particular sector in the high-yield market suffering. Among companies in high yield, we favour issuers that have durable business models, such as the telecommunications sector, with solid earnings and free cash flow generation throughout the economic cycle, in addition to strong liquidity
Another area of interest in fixed income is AT1s – European bank subordinated debt. We’ve long held the view that Europe’s banking system has vastly improved since the European Debt Crisis, due to the enactment of stringent reforms. Examples include the demand for much higher Core Tier 1 ratios and the adoption of a single supervisor at the ECB, which has meant bank balance sheets have become much more robust. From a profitability point of view, as European rates rise, banks’ net interest margins improve, further increasing their valuations. In addition, fears of a eurozone break-up and the implications that could have on European banks now appear remote, particularly given the recently broad political willingness to continue to strengthen the single-currency region. Within AT1s, we favour large-cap European banks, which are national champions and are of significant importance to their domestic countries.
A third area which should be looked at within higher-income fixed income is securitised debt, particularly collateralised loan obligations (CLOs) – loans to SMEs which are pooled into a special purpose vehicle. In a CLO, there are typically over 200 individual loans, with strict rules governing factors like the maximum exposure per obligor and per sector. In addition, they have built-in defensive mechanisms called “triggers”, which are particularly relevant for those investors in the higher-up tranches, which we favour: if certain credit metrics are breached due to adverse market conditions, investors in the bottom tranches may suffer losses, whereas those in the medium and top tranches are not only insulated, but would see their principal begin to amortise, lowering their exposure and thus reducing risk further.
This is one of the reasons why, since 1993, not a single AAA or AA CLO has ever suffered an impairment. Despite CLOs’ defensive structure, the returns they offer today are very elevated. European CLOs stand out as particularly cheap, despite fears of a full-blown energy crisis in Europe this winter becoming unfounded and the expectation of a deep recession going from high to very low.
Though we are optimistic on high-income strategies throughout 2023, we are not oblivious to the various risks. With this in mind, investors should adopt an approach which diversifies both across segments and within them, rather than taking large single-line bets. Fixed income funds that offer this multi-segment approach should be looked at in earnest this year, as the level of yields on offer remain elevated, with significant opportunity to add value over the medium term.