Looking to the next phase of the credit cycle

By Kunal Mehta, head of fixed income specialist team, Vanguard Europe. 

• A decline in liquidity is one of the biggest challenges facing bond investors today.
• As macro developments continue to weigh on markets there is likely to be a clearer demarcation between higher and lower quality companies.
• Against this challenging backdrop, we believe that security selection across fixed income markets is set to play an important role in helping to generate long-term returns for active bond investors.  

The recent shift in a number of structural factors is now contributing to a decline in liquidity (the ability to sell a bond at a reasonable price in a reasonable amount of time) for fixed income investors.

Interest rates are rising, inflation is up, volatility is on the increase and geopolitical risk continues to weigh on markets. However, the interplay of these macroeconomic developments is only part of the challenge facing fixed income investors at the moment.

The changing emphasis of global central banks means that while quantitative easing (QE) was used to stimulate economic conditions after the global financial crisis (GFC) and the Covid-19 pandemic, in today’s more inflationary environment, central banks are now reining back, or ‘tapering’, their asset purchases.

QE has been an important prop to both bond and equity markets in recent years. The combination of abnormally low interest rates and large monetary stimulus programmes has benefited almost every asset class.

However, central bankers have been keen to see interest rates return to levels closer to historical norms for some time. This would give them greater ammunition to tackle inflation within the economy in the event of a new financial crisis or recession.

So as markets begin to adjust to a period of ‘normalisation’, the impact is being watched closely as it ushers in the next phase of the credit cycle. At Vanguard, our active fixed income portfolio managers are thinking about these developments in terms of three Ds – dislocation, devaluation and demanding conditions.

Opportunities in a dislocated market

Fixed-income investors have not needed to worry about liquidity for the past decade when the rising tide lifted all boats, but in today’s more volatile and dislocated market, they need to be more discerning.

As markets adapt to the changing macroeconomic environment and become less dependent on liquidity, we believe that this will lead to further dislocation in some segments of the credit market. With less liquidity, investors typically become more selective with their cash, which can lead to greater polarisation between the winners and losers as stronger names receive more investment. We also expect to see a degree of credit-issuer and yield-curve dislocation, resulting in some credits and points on the yield curve repricing to levels which don’t reflect their fair value, which we anticipate will generate further alpha opportunities.

Amid heightened volatility and dislocation, the underlying risk-return dynamics of active bond portfolios are more likely to be exposed. Making calls on the direction of bond markets in an attempt to generate returns (also known as ‘levered beta’)—which can at times pay off in risk-on scenarios—can fall down in more volatile environments. Relying solely on top-down decision making and macroeconomic indicators can expose portfolios to more binary and volatile outcomes.

In contrast, the alpha that investors can derive from a bottom-up approach involving fundamental credit research and technical analysis is amplified, adding even more opportunities and value than it would in less dislocated markets, providing fixed income investors stay focused and patient.

Stretched valuations

Bond valuations were stretched at the end of last year and while they are more attractive now, they remain relatively high even post the recent market sell-off. We believe, though valuations have reduced, there is still room for them to fall further. We are very close to the turning point, especially for investment-grade credit. Other risk assets, such as high-yield debt and equities, have not fully priced in the macroeconomic risks.

As market conditions become more challenging, the need for more labour-intensive research and more in-depth fundamental credit analysis will increase, which will place further demands on fund managers. We also anticipate a greater demand for high-quality bonds which will only increase as recession risks rise.

In our view, it’s prudent to prepare for recessions before they actually occur and bottom-up security selection is more important than ever to generate alpha from the resulting market dislocation. This has always been at the heart of our approach to active fixed income, in all market environments.

Security selection as fundamentals shift

We believe that fixed income markets offer a rich opportunity set in which to generate alpha for investors. As the extensive package of central bank support is removed, fundamental credit and bottom-up technical analysis is set to play an even more important role in generating returns than we have seen since the onset of the pandemic.

Credit research analysts and portfolio managers are in a position to identify the issuers where valuations rely too heavily on low interest rates and easy funding and can seize the resulting opportunities for risk-adjusted alpha as fundamentals shift.

In our view, now more than ever is the time to derive alpha from genuine security selection across diversified sources, without taking excessive top-down directional risk.