Partner Insight: Five key questions for fixed income investors

In brief

Recession is our base case, and we expect some companies to be hurt by rising funding costs, but the near-term risks are mitigated by the extended maturity profiles of debt held by corporations.
China faces short-term economic challenges and long-term structural issues, with implications for the global economy.
With the distortions created when rates rose abruptly after cash earned near zero for more than a decade in the wake of the global financial crisis, the current cash rate of 5%-plus marks a shift that will broadly impact markets and portfolio management.
We are gradually adding duration in our global fixed income multisector portfolios, largely by finding relative value opportunities in curves and countries as some economies cannot deliver rate cuts priced into the markets.

In meetings with clients and prospects and discussions with colleagues, five questions have frequently arisen in the context of fixed income. Below are the questions and my answers.

What would a recession look like and what follows?

For some time, our base case has been for a recession. Some of the leading indicators have been deteriorating, and money supply has been significantly contracting both in Europe and the United States, and of course financial conditions have tightened in response to elevated real rates. Exhibit 1 shows the New York Federal Reserve Bank's recession indicator, which measures the probability of recession 12 months ahead. The latest reading is elevated, at 71%. We have charted the spreads in high yield alongside this indicator as a proxy for risky assets, and the current level of spreads indicates risky assets are now pricing in a soft landing.

But given the long lags in the impact of funding costs affecting consumer and corporate balance sheets and how anticipated a recession has been by management and consumers alike, a recession, if only a mild one, remains our base case for now.

However, the more the Fed and other central banks press forward with rate hikes without visibly affecting the real economy or inflation, the greater the risk that something breaks and a more severe recession results.

Such a crisis could be triggered by an unexpected systemic-risk event. With rapid moves in rates and levered balance sheets, both public and private, the market has been left fragile, as evidenced by the US regional banking crisis in March and the UBS takeover of Crédit Suisse.

Looking ahead, beyond any recession in the near term, we expect slightly higher growth and slightly higher inflation than prepandemic.

Are balance sheets vulnerable?

The private sector benefited from the low funding costs that accompanied the quantitative easing policies of central banks after the GFC. They were also helped by the fiscal splurge during the pandemic. This led to a period in which the private sector engaged in unsustainable capital allocation and operated under unsustainable financing structures. Not much of the liquidity made its way into productive investment in the economy. Instead, it ended up rewarding shareholders through share buybacks or M&A.

We are concerned about the trajectory of margins at this point in the cycle, particularly in the case of levered companies with weak business models and little pricing power and those with management teams that are unrealistic about the hurdles they face. We rely on the strength of our global research platform to identify the winners and the losers.

One of the factors we are focused on is refinancing risk. Exhibit 2 below shows the increase in yields in euro and US-dollar high-yield markets relative to the average coupon. Exhibit 3 plots the maturity profile of high yield companies by region. Over the past several years, high-yield and investment-grade companies have done a good job of extending their maturity profile, which is key when they need to refinance and step up their funding costs. As Exhibit 3 indicates, companies face the maturity wall in about twelve to eighteen months, so it will take a little longer for challenged balance sheets to perceptibly impact the market.

Investment-grade, large-cap companies have also extended the maturity profile of their debt. And US consumers have been refinancing mortgages over the past several years, pushing out higher aggregate funding costs.

In sum, we expect some companies will be hurt by rising funding costs, but it is hard to argue this is an imminent risk given the maturity profiles of debt owed by corporations…

This post was funded by MFS

The views expressed in this presentation are those of the speakers and are subject to change at any time. These views should not be relied upon as investment advice, as securities, recommendations or as an indication of trading intent on behalf of the advisor. No forecasts can be guaranteed. Please keep in mind that a sustainable investing approach does not guarantee positive returns and all investments, including those that integrate ESG considerations into the investment process, carry a certain amount of risk including the possible loss of the principal amount invested