Bond markets are rather jittery at present. While the latest UK data shows inflation is finally slowing down, this may not be enough to prevent further interest rate hikes.
The Consumer Prices Index (CPI) rose by 8.7% in the 12 months to April 2023, down from 10.1% in March, according to the Office for National Statistics. But this was a smaller-than-expected decline, according to the Economic Indicators document published by the House of Commons. “Economists surveyed by Reuters expected inflation to fall to 8.2%, while the Bank of England expected it to fall to 8.4%, it stated.
With everything still to play for but opportunities undoubtedly appearing, we look at the world of fixed income and where fund managers are currently finding the most value.
Although inflation remains persistent in the UK, it’s trending lower in other major developed economies, according to Richard Woolnough, manager of the M&G Strategic Corporate Bond fund. “Investors expected the US Federal Reserve to raise rates in May before pausing, while the European Central Bank remains hawkish,” he said. “Corporate bond markets saw low volatility and historically high yields, as resilient balance sheets supported credit.”
While Richard doesn’t believe the UK is heading for recession, he expects the yield curve to steepen and remains broadly neutral on duration. “We continued to increase our exposure to utilities, which, in our view, remain cheap and have proved resilient,” he added.
The Bank of England’s Monetary Policy Committee has now increased interest rates 12 consecutive times. It currently stands at 4.5% and the next meeting is on 22nd June 2023.
In early May, the Bank of England revealed the MPC voted 7-2 to increase the rate by 0.25 percentage points, with two having preferred to maintain the 4.25% rate.
“The pace at which domestic inflationary pressures ease will depend on the evolution of the economy, including the impact of the significant increases in Bank Rate so far,” it stated. “Uncertainties around the global financial and economic outlook remain elevated.”
It’s a broadly similar situation in the United States, where stronger-than-expected US inflation have helped fuel expectations of further interest rate hikes. The US banking system is “sound and resilient”, according to a statement issued in early May by the US Federal Reserve.
“Tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation,” it stated. “The extent of these effects remains uncertain. The Committee remains highly attentive to inflation risks.”
We experienced one of the strongest recent markets for risky assets in the first six weeks of this year, according to Gregoire Mivelaz, co-manager of the GAM Star Credit Opportunities fund. “Since mid-February the market went somewhat into reverse amid concerns about core inflation and its impact on terminal rates,” he said.
More broadly, Gregoire believes subordinated debt currently provides quality income – and he’s adamant this is what fixed income investors should be looking for in the current environment. “Subordinated debt provides safety, income, attractive valuation levels combined with very attractive fundamentals and very supportive technicals,” he explained.
Looking ahead, he remains optimistic. “I think it’s more a wakeup call for investors to realise that 2023 is all about quality – and quality income, which is exactly what subordinated debt can provide,” he added.
Dickie Hodges of the Nomura Global Dynamic Bond fund sees value in fixed income market but believes the probability of risk asset volatility has increased. “We have repeatedly warned that US inflation, whilst it would gradually fall throughout the remainder of 2023, would not fall sufficiently for the Federal Reserve to cut rates in late 2023,” he said. “This remains the case, in our view.”
This has led to some changes within his fund, which takes an unconstrained approach and has a focus on delivering total returns. “We have adjusted our exposures within both the convertible and high yield sectors of the portfolio, reducing allocations to more cyclical names that could be more vulnerable to an economic downturn,” he added.
The key is choosing the right holdings. Ariel Bezalel, manager of the Jupiter Strategic Bond fund, highlighted the “enormous flexibility” he has when it comes to choosing positions.
In a recent video update, he pointed out that the strategy can invest globally across the ratings spectrum, encompassing government bonds, investment grade, and high yield bonds.
“We have no limits across those different subsegments within fixed income so it’s about trying to cherry pick the best ideas in terms of where we see really compelling de-leveraging, corporate credit stories,” he explained.
Ariel and the team also take macro views into account, particularly where he believes the interest rate cycle is beginning to turn and look more favourable for fixed income investors.
“Conversely, sometimes fixed income can be a bit more volatile,” he added. “What we also try and do is to try and mitigate risk using different instruments at our disposal.”
Another fund that could be a good option given the uncertain backdrop is the Baillie Gifford Strategic Bond fund, which invests in a concentrated portfolio of primarily UK fixed income names.
Its co-manager, Torcail Stewart, sources ideas from across the investment grade and high yield universe, driven by fundamental, bottom-up stock analysis. However, the portfolio is well diversified and usually contains 60-85 companies.
Torcail explained more about here he is finding opportunities today in this video interview recorded for Chelsea Financial Services clients:
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the author and fund managers do not constitute financial advice. The mention of specific securities and funds is for illustration purposes only and not a recommendation to buy or to sell.