What keeps a fixed income manager awake at night?

Author: Marco Giordano, fixed income investment director at Wellington Management

Several factors of the macroeconomic environment are currently in the crosshairs of fixed income managers.

1. Global Tensions

Our geopolitical strategists are closely monitoring the dangerous situation in Ukraine. Ukrainian troops were forced to withdraw from the city of Avdiivka, losing a city for the first time in almost a year. Disruptions to global maritime traffic in the Red Sea continued after the sinking of the British-owned ship Rubymar by the Houthis, which was carrying a cargo of fertilizers. In addition to potential environmental damage, we continue to see upward pressure on maritime cargo insurance and short-term pressure on freight rates.

2. US Government Shutdown

Congress avoided a US government shutdown by reaching an agreement to fund different parts of the government until March 8 and March 22, respectively. The US Senate is also working on a longer-term bill that will fund the government until October 1. Our concern is that the current Speaker of the House has an extremely narrow voting margin and is at the mercy of small sectors of his group. Government legislation, normally a slow process, may prove especially difficult in the coming months.

3. Who does the ECB set rates for?

Since the creation of the euro, one of the biggest challenges for the ECB and, consequently, for European investors, has been to set policies for several countries. The monetary union brought together 12 countries at the time of the euro's introduction in 2002, and has grown to 20 today, with Croatia being the last to adopt the euro last year. The return of the growth-inflation dilemma extraordinarily complicates the task of the ECB, as the divergence of data remains wide. For example, Malta's unemployment rate is 2.6%, while in Spain it stands at 11.6%; general inflation ranges between 1.7% in Cyprus and 4.7% in Estonia. In this context, poor data in Germany particularly stand out in relation to the rest of the euro zone, and particularly with peripheral countries. While German industrial production has been contracting since the second half of 2022, Spanish and Italian services continue to accelerate, partly helped by the allocation of liquidity from the Recovery Fund.

If the ECB set rates only for Germany, we would probably have already seen significant cuts; if it set rates only for peripheral countries, perhaps the cuts could be delayed beyond June. The central bank's extended policy of setting rates for the average means that rates will probably be restrictive for Germany just when it needs the opposite. This is a situation opposite to what has taken place since the early 2010s, when Germany imposed strict fiscal discipline on southern Europe.

4. Bond market liquidity

It has been a constant concern since post-crisis policy deliberately reduced bank balances and their market-making capacity. This issue has increasingly been in the spotlight of investors and regulators, following the increase in volatility, quantitative tightening programs and the risk that exogenous shocks (such as the gilt crisis in 2022) cause a depletion of liquidity. The International Capital Market Association (ICMA) has recently published an analysis of the five main European sovereign debt markets, according to which, while liquidity is generally good, "market players accept that the new normal is a circumstantial increase in volatility, with a rapid evaporation of liquidity and a sharp revaluation of risk". This is nothing more than another reminder of the importance of adapting to a new market regime.

5. Defaults in the high yield segment

Company defaults worldwide increased to 4.8% at the end of last year, due to higher debt costs, inflation, and weakening fundamentals. Although this is undoubtedly an increase from the low levels observed in recent years, we could be close to the peak. Thanks to the strength of the balance sheets and the improvement of macroeconomic prospects, it seems unlikely that there will be an economic cycle without significant surprises to the downside. Once again, defaults will be idiosyncratic in nature and mainly from companies not only with poor balance sheets, but unable to grow in them.

Investment opportunities by sectors

The sectors where we currently see opportunities are:

• Given how prolonged and uncertain the rate cycle has been this year, we continue to bet mainly on higher quality total return strategies less limited by benchmark indices. This could include sovereign and currency global strategies that usually shine during these periods or unconstrained strategies that have the ability to navigate the late cycle by flexibly allocating to different sectors.

• Core fixed income strategies, and particularly credit, are becoming increasingly attractive. High-quality fixed income is attractive both from an income generation and capital protection point of view, as it offers a combination of carry and significant upside potential in a low-risk environment. The incomes from these strategies are not only attractive in themselves, but also provide additional buffers against rate volatility.

• European investors looking to protect themselves from current volatility and uncertainty can obtain attractive incomes through high-quality bonds, both from local and global markets.

• Keeping cash in portfolio allocation could be less beneficial in the long run. In the last two years, we have observed significant flows into cash and monetary products, and although obtaining a good return in an uncertain environment may seem attractive, the opportunity cost of not investing this cash in bonds is increasingly higher. The returns of high-quality bonds represent a similar income stream to cash, while offering protection against falls, in case central banks carry out rate cuts this year. As for when to move from cash to fixed income, historically it has been worth anticipating the last rise, rather than delaying it.

• Keeping cash in portfolio allocation could be less beneficial in the long run. In the last two years, we have observed significant flows into cash and monetary products, and although obtaining a good return in an uncertain environment may seem attractive, the opportunity cost of not investing this cash in bonds is increasingly higher. The returns of high-quality bonds represent a similar income stream to cash, while offering protection against falls, in case central banks carry out rate cuts this year. As for when to move from cash to fixed income, historically it has been worth anticipating the last rise, rather than delaying it.

• Both high yield and emerging markets remain attractive from the yield-to-worst perspective, but we expect volatility to continue along with geopolitical risk. Although fundamentals may worsen as delayed political effects are reflected in the economy, corporate profits have remained strong so far. In particular, in Europe we have not seen the same leverage in High Yield as in previous cycles.