Fixed income markets were volatile for most of last year over stickier-than-expected inflation and a historic tightening of monetary policy from central banks. But in recent months, we have seen a clear shift in direction, with inflation drifting lower and central banks signalling they may be at the end of their hiking cycle. With these two significant drivers of negative returns abating, we believe the outlook for high quality corporate bonds looks markedly brighter for 2024.
Strong performance drivers
Against this backdrop, investment grade corporate bonds look particularly attractive, with yields at historically high levels, meaning investors no longer need to chase yield via higher-risk assets.
As credit investors, one of the biggest opportunities is the additional yield earned over gilts or the credit spread. Currently, the yield premium in sterling corporate bonds over benchmark gilts is 135 basis points, which gives us an additional tailwind to performance relative to government bonds.
Additionally, wipe out yields - the level of yield move required to ‘wipe out' a year of income - in corporate bond markets are very attractive versus history and currently stand around 100 basis points. So, the current opportunity in sterling credit is very attractive - both in terms of yields and spreads.
High-quality fixed income is looking more attractive from an income perspective
Source: Fidelity International, Bloomberg data, 31 December 2023. Equity Gross Aggregate dividend yield Share Index. Sterling IG Credit = ICE BOfA Sterling Corporate & Collaterlized Index
As the effect of monetary tightening starts to feed through to the economy, our view is that a recession seems increasingly likely. For credit investors, the nature of the default cycle going forward will be key. As borrowing rates have increased, so have insolvencies, rising by 10% year-on-year - indicating the risks to lower-rated corporates.
This further supports the outlook for high-quality issuers. In a normal cycle, there's not much to choose between different rating buckets as they will all offer similar risk premium after expected defaults. However, it's in a rising default environment that we start to see some significant discrepancies and expected returns start to fall significantly as we move down the credit spectrum.
The clear message is that if investors are concerned about rising economic risks resulting in a deterioration in credit fundamentals and rising default rates, then sterling investment grade credit markets currently look compelling.
Across both Sustainable Moneybuilder Income and Short Dated Credit Bond fund portfolios, we have enhanced the defensive characteristics that are fundamental to our core philosophy as we look to position for a recessionary outcome. We have increased our weighting to utilities, which are inflation protected and defensive in a downturn. We've also reduced exposure to cyclicals and banks. Across sectors, we have a preference towards secured bonds, which translates into a meaningful overweight.
We've also shortened some of our credit exposures by taking our exposure from the long end of the credit curve and moving it down to the front end in both portfolios. In terms of our rates exposure, with the inversion of the yield curve, we're now underweight the 10-year part of the curve and overweight the two-year part. Again, this makes us more geared towards a recessionary outcome if central banks start cutting rates. We have also been adding other types of portfolio hedges that are not correlated with some of the credit returns that we would generate in a risk-off environment - whether this is through some index protection or buying dollars, for example.
Within IG, position on the curve is an important consideration
Source: Fidelity International, 31 December 2023. ICE BOfA indices used. € IG Credit 5-yr = ICE BOfA 5-7 Year Euro sterling Index € IG Credit 3-5yr = ICE BOfA 3-5 Year Eurosterling Index.
As big debt maturity walls loom in 2025 and 2026, we have allowed our high-yield exposure to run down and out of both portfolios. Refinancing and default risk among these more indebted businesses looks likely to rise as conditions tighten. We have 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.
As we move into 2024, it is likely to be another challenging year, but we expect to see to a shift in the balance of power from equities to fixed income. We are already seeing the impact of the initial rate cuts on the economy and as the transmission of higher rates starts to be felt more heavily, we believe our more defensive positioning will hold us in good stead.
The short end looks particularly attractive. With the inversion of the yield curve, investors can now achieve more yield in short dated corporate bonds versus longer dated bonds. As noted earlier, we have been implementing shortening trades in both portfolios, 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.
More broadly, higher levels of volatility and 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 are strongly positioned to take advantage of this environment by identifying mispriced securities.
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. Fidelity's range of fixed income funds 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 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 (Key Information Document for Investment Trusts), current annual and semi-annual reports free of charge on request by calling 0800 368 1732. 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. UKM0124/385981/SSO/NA