By Hamlin Lovell, NordicInvestor 

Excitement about the World Cup is a good reminder that the best offense may start with a good defence.

While the Federal Reserve’s aggressive rate increases threaten to overshoot and engineer a recession in the US, market prices still reflect expectations for a soft landing. Against this backdrop, we believe fixed income investors, including in the Nordics, should maintain a defensive portfolio stance while being prepared to quickly shift to offence should valuation cracks emerge and present attractive opportunities. With an inverted yield curve and yields at or near a cyclical peak, we see no need to play aggressive offense and take undue risks when seeking sufficient yields.

Investment grade debt looks more attractive given the challenges heading into 2023. That said, our current more risk-off stance, along with the dollar’s supremacy across fixed income markets, could begin to shift in the new year as the Fed finishes its hiking phase and settles in to a maintain its restrictive higher terminal rate. This could mean below-investment-grade and emerging market (EM) assets look more attractive again in 2023 and begin to eat into US investment grade’s dominance.

The challenge for investors will be timing the pivot from defence to offense.

Key Convictions for 2023

2. We see several actionable trends in the new year for investors in fixed income markets.

Focus on US fixed income now before looking more broadly in 2023.The US is still the place to be, but we’re cautious everywhere. A stronger dollar has raised hedging costs for foreign investors, but US investment grade credit remains attractive due to elevated all-in yields and demand for higher-quality dollar-denominated assets. While the move higher in government bond yields and wider credit spreads have created some attractive relative value opportunities, we remain cautious given tightening financial conditions, a slowing economy, and lower corporate earnings. Despite enticing excess spreads in Europe, we’re wary on non-US investment grade credit for now because the differential may widen amid challenging economic conditions facing Europe in the next six months. We expect the dollar’s dominance to peak next year and for currencies to shift to a more stable regime (rather than a reversal).

2. Maintain an underweight in leveraged finance with an eye to selectively adding risk.

Yields appear to compensate for soft-landing risks but not for a harder recession scenario. High yield has continued to cautiously follow the bear market rally in equities, with option-adjusted spreads now in the mid-400 basis-point range – very tight relative to historical recession outcomes. Arguably, the strong consumer and a higher-quality issuer base warrant lower spreads, but spreads rarely trade at fair value. Typically, in a recessionary scenario, spread valuations will overshoot and become wider than what’s justifiable, and we are far from such levels today.

Where are the leveraged loan investors? The big mystery in leveraged loans has been the dearth of investors we would expect to see amid current conditions: Historically, when the Fed is bearish and hiking rates, interest rates at the short end are rising, inducing loan demand from long retail investors. That has not been the case recently, and we think the divergence from historical norms could reflect fear of the underlying asset class and of risk more generally. Loan spreads are more compelling, but while floating rates have offered a tremendous protective benefit in 2022, this will be less true in 2023. As default rates rise from near-zero closer to historical averages, we may be entering a period in which greater dispersion between credits calls for a thoughtful approach to tap the most compelling opportunities. Finally, the lack of demand is even more acute for mezzanine collateralized loan obligation (CLO) tranches, resulting in outsize spreads. While we believe significant price volatility lies ahead, carefully chosen CLO transactions could reward investors with compelling longer-term returns.

3. Keep an eye on trends in emerging market debt.

Emerging market debt may start to look more attractive next year. Despite challenging conditions in China and a few flashpoints elsewhere, emerging market (EM) growth is holding up better than developed market growth, signalling a widening of the growth gap that could favour emerging markets in 2023. EM spreads already offer a premium, particularly in high yield, yet returns remain vulnerable to broader risk aversion. We see longer-term value in EM corporate debt, but near-term macro uncertainty and risk-averse sentiment on EM could lead to some short-term softness. Our expectation for the US dollar to peak and stop appreciating around mid-2023 should also remove a significant headwind against EM debt.

4. With credit issuance at a standstill, watch for friendlier market conditions in 2023.

The secondary markets are functioning despite more constrained liquidity and stalled primary issuance. Current yields on both a spread and an absolute basis make financing new credit transactions challenging, and most issuance coming to the market consists essentially of “forced” deals that had been committed to months ago or were necessary to fund mergers and acquisitions (M&A) or required refinancing. We’re not seeing opportunistic transactions since it’s just too expensive to issue debt right now. With limited refinancing requirements in the year ahead and M&A transactions slowing, we’re seeing a dramatic slowdown in new issuance supply that should extend into 2023.

Lack of supply is providing technical support to the market, particularly in leveraged finance, in the face of retail outflows. For the loan market, difficult arbitrage due to the high cost of debt liabilities is resulting in a plunge in CLO formation – a primary driver of loan issuance. Despite the challenging conditions, we’re still seeing demand for good businesses with prudent capital structures. The appetite for risk is still there, and we would not characterize these markets as dysfunctional at current levels.

5. Securitized products have taken a beating, but pockets of select opportunity remain.

MBS spreads have widened dramatically. Securitized products, especially residential mortgage-backed securities (MBS), have been hurt by rising rates along with a drop in demand as the Fed reduces its balance sheet. Investors have been leery about stepping into the demand void, resulting in a widening of spreads in US agency MBS in 2022 past levels last seen during the global financial crisis.1 This outcome is providing an attractive opportunity to add excess spread exposure for what is essentially US government-backed debt. Separately, the highest-quality tranches of CLO mezzanine debt, rated AAA and AA, are offering outsized yields relative to risks in both the US and in Europe.

Staying defensive, but ready to move

Recession risks continue to rise given the Fed’s march toward a potential policy overshoot, and while the US may still sidestep a contraction, recession and stagflation appear to be a foregone conclusion in Europe, and the outcome of China’s 20th Party Congress dashed any hopes for a more growth-favourable policy pivot there. While corporate credit spreads have widened in 2022 from ultra-tight starting points, valuations generally are not yet at levels that fully acknowledge recession probabilities. Taken together, we believe these trends justify a continued more defensive stance that favours investment grade over high yield and the US over Europe and emerging markets. In fact, at current yields, we believe allocating a portion of the portfolio to cash equivalents is a viable short-term option. However, we anticipate that valuation cracks will likely develop in the months ahead, and we are looking to move from a defensive posture to an offensive counterattack when opportunities emerge.