While economic data releases have been mixed but overall healthy, we’re starting to see suggestions of a decline in response to the pressures of persistently high inflation. Yields have also broadly been moving lower, albeit with lots of volatility along the way.
Ongoing banking sector concern is fuelling a lot of this volatility. Continued problems within the sector could lead to the lower availability of loans, increasing downward pressure on the economy. Alongside this, the US Treasury yield curve is the most inverted it has been since the 1990s, suggesting a slowdown and a cut in US rates sometime during the second half of the year.
In Europe and the UK, we have a clear disconnect between the market and central bank messaging. The European Central Bank and Bank of England are signalling further rate hikes, yet the market is pricing for a pause. Which way the coin falls will ultimately be decided by future data releases.
As a side note, any pause should result in greater stability in rates, which would make investment duration calls easier to make.
But back to the main narrative. We know from prior years that when loan conditions tighten, or demand for loans falls quickly, spreads move wider as risk increases in the credit markets.
Right now, the market is indicating that recession risks have been brought forward, but spreads are suggesting everything is OK, leaving investors to decipher this contradictory messaging.
Within our portfolios, we have been taking action to mitigate an outlook of widening spreads. We have slowly been trimming our high yield (HY) positioning in favour of investment grade (IG). But to add a second confusing message to the mix, the HY market has held up very well year to date, largely due to low levels of refinancing risk. You may recall, over the past few years, lots of HY issuers savvily came to the market to refinance at ultra-low rates. Supply is also low at the moment, and default rates remain negligible. This combination of low refinancing risk, low supply and low default risk has supported positive performance this year.
Nevertheless, as we experience a slow-motion move towards recession (perhaps the most well-publicised recession ever), we are shifting away from higher-beta, cyclical sectors (which benefited disproportionately from the zero-rate environment) and moving up in quality. Within our global HY allocation, we have been shifting away from B and CCC issuers towards higher-rated assets.
Sector-wise, we’ve been reducing consumer discretionary sectors on the back of positive performance – particularly travel and leisure names – in favour of defensive sectors like telecoms and communications. Essentially, we’ve shifted from credit risk towards duration risk.
Within our IG allocations, senior financials are offering significant spread advantages versus industrials and corporates. We have been adding exposure to these papers, which sit at the highest level of the capital structure, where we see significant spread advantage and where yields are particularly attractive, on a case-by-case basis.
Where do we see value?
We’re finding pockets of opportunity across the market where we can take advantage of the current uncertainty; for once, we can see some value in every segment of the market. Short duration now offers yields of over 5%, up from the zero-skimming lows a couple of years ago. Moving up the risk spectrum, HY offers close to double-digit yields while subordinated financials offer yields well into the double-digit range.