The bond market may have reached a bottom with a recession priced into assets, but risks remain without careful selection, according to Colin Finlayson, fixed income investment manager at Aegon Asset Management.
Finlayson says turmoil in investment markets may have reached a point where assets look affordable again.
“We do not pretend to have a crystal ball or know what will happen. The only certainty for us is that anyone who claims to have the answers most likely does not. We expect to continue to see elevated volatility until the end of the year, although our base case is that it will slowly diminish from the highs seen in the first quarter of 2022.
“Central bank words and actions will continue to be the dominant market driver. We are unlikely to have seen the full repricing of government bond markets, but we feel we are close to the end of that process. This, in turn, means that we are also unlikely to have seen the full impact on risk assets or credit spreads either.
“But corporate bonds – both investment grade and high yield – do not look bad on a total-return basis after the dismal start of the year. While they could both reprice wider (down) if the slowdown becomes more pronounced, the violent market repricing has opened-up more opportunities to capture alpha than we had at our disposal on 1st January.”
Finlayson explains his positioning in light of this turning point for the market, and says tactical opportunities are now emerging.
“While we may be yet to see the peak of the rates market sell-off, we would like to be much more balanced,” he says. “We have removed the short bias in our headline duration position and are now neutral with a bias to move longer.
“Tactical opportunities are very likely to arise either side of our positioning over the remainder of the year, and we now prefer to approach opportunities from a more balanced stance to manage both upside as well as downside risks at these higher levels.
“On the credit side the picture looks similar – reasonably nimble credit risk allocation at the beginning of the quarter, but gradually adding back credit risk as credit spreads hit recessionary levels.”
Finlayson believes that while major market risks remain, it is true of most sell offs that investors tend to overshoot when fear takes over, leaving good opportunities for asset managers to find bargains. A recession, if it comes, is already reflected in prices.
“In terms of market pricing, spreads in Europe in investment grade and high yield – both in cash bonds as well as synthetic markets – reached or exceeded that of the peak hawkishness of the 2018 hiking cycle, to then price in a recession.
“Whether we experience a recession or not remains uncertain, although if one were to come it is already reflected in the price. Of course, markets tend to overshoot both on the upside as well as on the downside. Further, if we assume a ‘normal’ recessionary credit spread distribution, the tails this time around are much fatter due to the geopolitical situation,” Finlayson said.
Finlayson believes that credit spreads are currently offering good value on a medium-term view. “Normalising for black swan events, corporate balance sheets and households are strong, cash-rich and liquid. The various implied interest coverage ratios are at multi-year highs,” he said.
“However, the front end of the government bond markets has sold-off so much that it is now again both an asset class to at least be under consideration, and a potentially more powerful risk hedge.
“This is not a directional call on the front-end rates markets, rather a quest to find the most cost-effective way to protect our tail risks. This is precisely why we have concurrently added both credit risk gradually as well as interest rates risk in the portfolio over the course of the quarter.”
