Partner Insight: Exploiting inverted curves

The yield curve is inverted which offers investors an exciting opportunity to increase yield by taking less interest rate and credit risk. With the UK set to enter recession, Fidelity fixed income managers Kris Atkinson and Shamil Pankhania discuss why a defensive income offering looks attractive via short dated, high-quality corporate bonds

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Partner Insight: Exploiting inverted curves

Looking towards 2024, we remain positive on short dated sterling investment grade credit with there being attractive opportunities in both yield and credit spread terms. As credit investors, one of the biggest opportunities that we have is the additional yield that we earn over Gilts, the ‘credit spread'. Currently, the yield premium in short-dated (1-5yr) sterling corporate bonds over benchmark Gilts is 153 basis points, which gives us an additional tailwind to performance.[1]

It's hard to predict the future, although it seems inflation is declining and each additional data print reinforces that. However, with growth looking anaemic, we're teetering along the edge of a recession, which makes our conviction around defensive fixed income much higher than risky assets.

There's been much talk about the lack of transmission between higher rates to the real economy, but we're now starting to feel the effects of the initial rate hikes. We're moving towards late-cycle dynamics, with rates remaining high and credit conditions tightening. We're seeing this through an increase in the level of volatility and dispersion within individual equities and credit spreads. This transmission mechanism will likely continue through 2024 and probably beyond that. With an inverted yield curve, there's a unique opportunity for investors at the short end of the curve to add yield and take less risk.

Assessing the potential risks ahead

A potential surprise in the market could come from the ongoing geopolitical backdrop. There are multiple conflicts globally that could tip over into broader regional conflict which could have serious implications for markets. We do think there should be some risk premium, given the geopolitical uncertainty surrounding the potential of involvement of various state-actors in the situation.

Furthermore, there could be a surprise to the market if inflation remains stickier than expected. With the market already pricing in cuts for next year, an uptick in inflation (which could potentially come from shocks associated with geopolitical risks) could push yields back up again. Fortunately, under this scenario, short-dated bonds may outperform longer-dated bonds as they are less sensitive to interest rate risk.

A winning formula

We aim to generate alpha by delivering an excess yield over the index, which primarily comes down to active credit decisions, and this is how 2023 has panned out with the bulk of excess return coming from our excess yield over the index. This excess yield is largely achieved via three strategies; being underweight the highest quality quasi-sovereign and supranational names, adding selectively in callable financials and taking very conservative high yield exposure (capped at 10%).

From a single-name perspective, some of our high conviction names in the secured space have supported alpha such as AA, Center Parcs and Telereal (secured on BT telephone exchanges). Our excess yield and single-name selection will remain key for 2024.

As big debt maturity walls loom in 2025 and 2026, we have allowed our high-yield exposure to run down and out of the portfolio. Refinancing and default risk among these more indebted businesses looks likely to rise as conditions tighten. We believe high yield offers a relative lack of compensation in spread terms versus investment grade credit, where our preference is for defensive sectors such as secured bonds and utilities. We've reduced portfolio credit beta by shifting credit exposure to the shorter end of the curve too, switching out of 2028 maturity bonds into 2025 maturity bonds from the same issuers, for example.

Opportunities abound for 2024

As the transmission of higher rates hits the real economy, we're positioning ourselves more defensively. We've increased our weighting to utilities, which are inflation protected and defensive in downturns, and lifted our Gilt exposure to support liquidity in the portfolio. Across sectors we've a preference towards secured bonds, which translates into a meaningful overweight.

The short end looks particularly attractive. With the inversion of the yield curve, investors can now achieve more yield in short dated corporate bonds (see chart) versus longer dated bonds. Accordingly, we've been implementing shortening trades in the portfolio, allowing us to pick-up more yield for less risk. This positions the portfolio more towards a recessionary outcome if central banks have to cut rates, given the short end is particularly sensitive to interest rate policy.

Sterling investment grade yield to maturity, 5-7yr minus 3-5yr

Source: Fidelity International, 31 October 2023. ICE BofA indices used. £ IG Credit 5-yr = ICE BofA 5-7 Year Eurosterling Index and £ IG Credit 3-5yr = ICE BofA 3-5 Year Eurosterling Index.

Higher levels of volatility and economic uncertainty offers a unique opportunity for our active management approach as negative headlines tend to get an oversized reaction from markets. With our research capabilities, we can take advantage of this environment by identifying mispriced securities and help to deliver a defensive source of income for investors in the Fidelity Short Dated Corporate Bond Fund.



Important information

This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Due to the greater possibility of default, an investment in a corporate bond is generally less secure than an investment in government bonds. The Fidelity Short Dated Corporate Bond Fund can use financial derivative instruments for investment purposes, which may expose them to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes.

Investments should be made on the basis of the current prospectus, which is available along with the Key Investor Information Document, current annual and semi-annual reports free of charge on request by calling 0800 368 1732. Fidelity only gives information on products and services and does not give investment advice to retail clients based on individual circumstances. Any comments or statements made are not necessarily those of Fidelity. Issued by FIL Pensions Management, authorised and regulated by the Financial Conduct Authority. Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM1123/382357/SSO/NA

[1] Source: Fidelity International, Bloomberg, ICE BofA 1-5 Year Sterling Corporate Index, 23 November 2023.

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