Despite a still unclear interest rate situation and a recession that could increase defaults, the fixed income market, after a nightmarish 2022, has restarted. Falling inflation makes it possible to initiate several interesting strategies on some bond categories. Government bonds, Asian fixed income, investment grade corporate bonds and high yield are the sectors that offer the best opportunities, albeit in a context of considerable volatility, which is however lower than it was last year.
Philippe Berthelot, head of money markets and rates at Ostrum AM and Alexandre Caminade, head of core fixed income and liquid alternatives at Ostrum AM, have answered journalist from the leading Italian magazine, Fondi & Sicav, Boris Secciani’s questions, sharing their current markets views and strategy.
Philippe Berthelot, Head of Money Markets & Credit Management at Ostrum AM, a Natixis IM affiliate
So far the European economy has avoided recession, of course a new downturn is possible, but we believe there is no reason to be overly pessimistic. In every economic downturn, both in America and in Europe, there are a good number of bonds of companies exposed to consumer demand that end up in default. At present, however, households can still count on strong liquidity, the result of the stimulus fiscal policies put in place during the pandemic and which now provide a safety cushion. For this reason, we expect defaults to increase but remain below the historical average. Among the 221 European companies we analyse, we have identified 13 names at risk of default. Even if all the groups in this set were in fact unable to meet their bond debts, this would result in a default rate of 3.2%. This is still significantly below the historical average of around 5%.
Having said that, we certainly live in a more complicated era than in the previous years, in which it was on the whole easier to manage a bond portfolio, with de facto default rates around zero or little more. the result is that a considerable amount of capital has been misallocated. At present, Euro Credit does benefit from all time high yields for more than a decade with more than 7.5% in € HY and more than 4% in € IG. In addition, European credit appears to be richer in opportunities than its US counterparts. Indeed, at investment grade level, across the ocean, yields of around 5% can be achieved compared to more than 4% on the Old Continent. The spread of US corporate bonds over Treasuries is narrower than that of their counterparts in the Eurozone. Not to mention that, for a domestic investor, due to the hedging costs of the US currency, it is definitely cheaper to invest in Euro bonds. Several Asian institutional investors may also prefer to invest in European credit for the same reasons.
Alexandre Caminade, Head of Core Fixed Income and Liquid Alternatives at Ostrum AM, a Natixis IM affiliate
As far as the US economy is concerned, we expect a soft landing scenario, with GDP growth expected to be around +0.8%. The deposit flight occurring at some regional banks is however slowing down. For the time being, the Fed, with the USD 300 billion measures it has put in place, is able to buffer what is so far a crisis of confidence and not instead a phenomenon generated by a significant increase in credit defaults. Although it has to be said that the commercial real estate situation certainly gives some cause for concern. As far as inflation is concerned, we expect it to be around +3.3% by the end of the year. This figure is not too far off the Central Bank's target, with the core figure expected to be around +3.4%. Consequently, the Fed will maintain status quo on rates from May onwards It is a different story for the Eurozone: our estimate is for GDP to increase by +1.1% (vs. a consensus of +0.5%) and for inflation to end the year at +3.7%. However, we believe that the core figure will fall much less than expected, remaining around +5.3%. Therefore, in our view, the ECB will continue to raise the cost of money during 2023.
With such fundamentals, there are still good prospects for investing in government bonds. Ten-year Treasuries trade at around 3.5% yield: the range from that level up to 4% is a good entry point. The Bund, on the other hand, is roughly at 2.5%, which can be considered close to its fair value. At these levels, it would be worthwhile to add duration exposure to one's portfolio. Favouring this investment thesis is the decreasing volatility in interest rates overall thanks to a Fed that is finishing raising the cost of money and may start cutting rates next year. However, visibility is also higher in Europe, despite the ECB being a few months behind in the cycle compared to America.
This means that the risks of fragmentation in the Eurozone and falling debt prices of peripheral countries are also greatly diminished. Several observers thought a year ago, for example, that the BTP spread over the Bund could exceed 250 basis points. Currently, the range between 180 and 200 is rather stable. The most pessimistic scenarios did not materialise due to the fact that many institutional investors were short Italian debt in 2022. The rising cost of money made the carry of such positions unsustainable against a better-than-expected political, economic and energy scenario.
Interview conducted in March 2023.
Data updated as of May 30 2023.
