Categories
Fixed Income
Credit investing amid heightened market volatility
Peter Becker
Investment Director
KEY TAKEAWAYS
  • Credit markets have repriced significantly since the beginning of the year, leading to a potentially more attractive entry point for investors.
  • Higher yields could offer the opportunity to earn more income from bonds and provide a cushion for total returns.
  • That said, downside risks remain, and selectivity is key.

Introduction


It has been a rocky start to the year for credit in 2022, with both year-to-date total and excess returns being starkly negative. What started as a duration-driven sell off has been exacerbated by macro headwinds including high inflation, the Russia-Ukraine conflict and tightening monetary policy. The revaluation in spreads and yields has been quite severe, although a number of macro risks seem to be abating. There are reasons to be constructive on the asset class and current valuations suggest an attractive entry point, but with volatility having also dramatically increased across risk markets and an uncertain outlook, caution is still warranted. Selectivity remains key in the current environment and an active approach could help to uncover attractive relative value opportunities.


A more balanced risk/reward profile


Investment grade corporate bonds returned -16.1% year-to-date1 against a backdrop of high inflation, tightening monetary policy and overall heightened macroeconomic volatility. A number of risks already appear to be priced in. In particular, the market has already significantly repriced rate hike expectations from the US Federal Reserve (Fed) since the beginning of the year. To put it into perspective, the federal funds rate is expected to reach almost 4% in the first quarter 2023 when the market was expecting the Fed to hike rates to around 1.5% at the beginning of the year2 .


Looking forward, top-down factors, especially inflation and the policy response to it, are likely to continue to drive the overall direction of markets and there is still a lot of uncertainty that could impact investor risk appetite. As we enter the late expansion phase of the cycle, credit spreads could widen further. The risks of recession and stagflation are not so easily dismissed anymore, both of which would have a negative impact on credit markets. A slowdown in global growth is already evident and there are a number of factors that could further weigh on growth, such as the ongoing war in Ukraine. Although it is likely that the war would have a more pronounced impact on Europe, so far growth in Europe seems to be holding up relatively well despite investor worries about a war-induced recession.


Inflation has also remained higher than expected, driven by tight labour markets, the Ukraine war and persistent global supply chain issues. Additionally, risk sentiment is fragile. This will make the job of central banks finding a balance between inflation and growth a tricky proposition should inflation remain persistently high. There is a risk that central banks could tighten monetary policy more aggressively than currently anticipated. A number of other global drivers are also negative for spreads, such as China’s zero-Covid policy as well as the war in Ukraine and their associated negative impact on growth, inflation and supply chains. This could mean market volatility remains elevated.


From an overall risk/reward perspective though, the market’s profile appears to be more balanced now that it did a few months ago. It is also worth noting that in non-recessionary periods, tightening financial conditions have generally resulted in more modest spread widening than during recessionary periods as evidenced by the following graph.


 


1. As at 15 June 2022. Returns are in US dollar (unhedged) terms for the Bloomberg Global Aggregate Corporate Index. Source: Barclays, Bloomberg


2. As at 16 June 2022. Source: Bloomberg


 


Risk factors you should consider before investing:

  • This material is not intended to provide investment advice or be considered a personal recommendation.
  • The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
  • Past results are not a guide to future results.
  • If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
  • Depending on the strategy, risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.


Peter Becker is an investment director at Capital Group. He has 25 years of industry experience and has been with Capital Group for three years. He holds a master's degree from The Ingolstadt School of Management. He also holds the Chartered Financial Analyst® designation. Peter is based in London.


Past results are not a guarantee of future results. The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment. This information is not intended to provide investment, tax or other advice, or to be a solicitation to buy or sell any securities.

Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. All information is as at the date indicated unless otherwise stated. Some information may have been obtained from third parties, and as such the reliability of that information is not guaranteed.