Evangelia Gkeka, Senior Manager Research Analyst, Fixed Income, Morningstar
The first quarter of 2023 was characterised by major swings in inflation and rate-hike expectations. Markets rallied in January on strong economic data, better-than-expected corporate earnings, and easing headline inflation figures. However, February brought higher-than-expected inflation numbers. In March, the failure of two US banks (Silicon Valley Bank and Signature Bank) and the forced takeover of Credit Suisse by UBS in Europe created fears of a global banking crisis and led investors to move to safe assets, including bonds. By the end of the quarter, these fears abated, and investors started focusing again on potentially more accommodative monetary policy steps in the quarters ahead. The table below exhibits the performance of key fixed-income indexes for each quarter of 2022, the full year of 2022 and the first quarter of 2023 (figures in percentages). As illustrated, the recovery over the past couple of quarters has been broad-based across government, investment-grade, and high-yield bonds.
Fixed-Income Fund Flows
Over the first three quarters of 2022, the majority of fixed-income funds suffered significant net outflows as investor sentiment deteriorated in light of the tightening cycle, inflation spike, geopolitical uncertainties, and economic growth concerns. However, as inflation started easing and economic data and corporate earnings were stronger than expected, investors started reallocating to European fixed income. Attractive yields and valuations across fixed-income sectors were the main drivers of inflows since the fourth quarter of 2022.
As the table above shows, global flexible bond, emerging markets, and high yield were among the categories that experienced the largest net outflows in 2022. Government-bond categories saw inflows, benefiting from demand for liquid safe-haven assets. In the fourth quarter of 2022, we continued seeing inflows into government-bond categories and started seeing inflows into investment-grade corporates. Emerging-markets categories continued seeing outflows, as did flexible-bond categories. However, here, at least in some cases, the volume of outflows was lower compared with previous quarters. Moving to the first quarter of 2023, most categories saw net inflows, most notably corporate bonds. Some categories within high yield and emerging markets also started seeing net inflows.
Best Performers in the First Quarter of 2023
- BlackRock Corporate Bond
- BGF Euro Corporate Bond
- Jupiter Strategic Bond
- Janus Henderson Strategic Bond
- Barings Emerging Markets Sovereign Debt
As fixed-income markets across different sectors recorded gains in the first quarter, we also saw positive performance from our universe of analyst-rated fixed-income funds. We examined the main drivers of outperformance of the best performers within select Morningstar Categories.
Within the GBP corporate-bond category, BlackRock Corporate Bond returned 3.8%, outperforming its peers by 1.4%. Credit added 82 basis points. The largest contribution came from senior bond holdings of Credit Suisse and trading positions in both UBS bonds and Additional Tier 1 securities during the volatile March period and subsequent sale of Credit Suisse. Higher-beta corporate hybrids also helped. Recently, credit risk was reduced with high yield representing the lowest exposure in 18 months. Duration added 63 basis points as the fund had a moderate long-duration positioning with a focus on US Treasuries and adding duration around peaks in yields. Lastly, yield curve positioning added 29 basis points as the fund held significantly fewer longer-dated bonds compared with the index, as five-year sterling bonds outperformed 30-year bonds.
Within the EUR corporate-bond cohort, BGF Euro Corporate Bond returned 2.2%, outperforming its peers by 0.7%. The majority of alpha came from security selection. Despite the volatility within the banking sector and the overweight position there, the fund had very little allocation to AT1 securities, which underperformed following the write-down of Credit Suisse AT1 bonds. Outside of financials, an allocation to corporate hybrids, mainly in defensive sectors, also aided returns. Macro also contributed, in particular a short 30-year euro interest-rate swaps and a short in five-year, five-year forward European inflation as medium-term inflation expectations fell as part of the risk-off moves in March. Long credit beta helped through good timing of rerisking and derisking over the quarter. Hedges implemented via the iTraxx Senior and Subordinated Financials indexes contributed as well. Lastly, sector allocation was additive, as allocations to utilities and noncyclical industrials fared better amid volatility.
Moving to the global flexible category, Jupiter Strategic Bond returned 3.6%, outperforming peers by 2.1%. Exposure to government bonds in developed markets was the biggest contributor as yields fell. Australian government bonds generated more than half of the positive contribution, followed by US Treasuries, while sovereign bonds in New Zealand also helped. In the emerging-markets space, the allocation to government bonds in South Korea was also a positive contributor. Within credit, corporate high-yield bonds in Continental Europe and the United Kingdom, as well as investment-grade corporates in developed and emerging markets contributed. Tactical exposure to European financials also added value. Not having exposure to US regional banks and Credit Suisse AT1s contributed on a relative basis against some peers. In expectation of a potential downturn, exposure to government bonds was increased, the corporate-bond allocation, particularly in cyclical sectors was reduced, while some credit hedges via EUR HY CDX were introduced.
Another strong performer within the global flexible category was Janus Henderson Strategic Bond. It returned 3.0%, outperforming its peers by 1.5%. Performance was aided by the fund’s significant long sovereign bond duration position. Corporate-bond holdings more focused on the US also helped. The team expected default rates in corporates to rise in 2023 given tighter financial conditions and headwinds to corporate fundamentals. Duration was increased a little from already elevated levels as the managers believe that inflation has been tamed and economic growth seems to be stalling. Already modest holdings in banking and insurance bonds were trimmed. Fund positioning remains long in quality sovereign bonds with a modest credit book.
Lastly, in the global emerging-markets bond category, Barings Emerging Markets Sovereign Debt returned 2.7% and outperformed peers by 0.8%. Top performers in the first quarter included overweights in Serbia, Mexico, and Brazil, as well as a zero weight in Ecuador and an underweight in Egypt. The managers see select opportunities where growth may surprise to the upside and continue to focus on countries that have diversified, competitive, and well-run economies able to withstand uncertainty. Over the quarter, the fund participated in new issuances of several investment-grade rated sovereigns, including Mexico, the Philippines, Indonesia, Hungary, and Romania, and on the high-yield side, Serbia and Morocco. The fund also cut exposure to zero in positions that are vulnerable in the current environment such as Ecuador, Jordan, and Greek banks.
How Things Stand
After a dramatic selloff in the first three quarters of 2022, fixed-income markets showed signs of stabilisation over the past couple of quarters. At the same time, investment flows also stabilized, with some categories of fixed-income managers seeing a partial recovery in the fourth quarter of 2022 and the first quarter of 2023.
In the first quarter of 2023, we also saw positive performance across our universe of rated fixed-income managers. In general, managers benefited from increasing duration, and allocating predominantly to high-quality sovereigns and/or defensive and noncyclical corporate sectors that offer the best risk[1]adjusted returns, in their view.
Additionally, managers that allocate across different fixed-income sectors have benefited from diversification effects so far in 2023. In 2022, the historical inverse correlation between safe-haven government bonds and corporate bonds broke down as all segments recorded significant losses. In the first quarter of 2023, we saw positive returns across the board. During periods of short-term volatility, such as in March when credit suffered from risk-off moves owing to headlines surrounding subordinated bank bonds, government bonds provided positive returns and damped volatility in portfolios.
Based on our recent discussions, the majority of managers have a cautious macroeconomic outlook as European economies and corporates are expected to face a challenging environment with inflation remaining elevated, while economic growth is expected to remain weak. In the current environment, managers are trying to avoid having exposure to cyclical and leveraged companies as recession risks remain high.
However, most managers have the view that the repricing of European fixed-income markets last year resulted in attractive entry points from a yield perspective. After years of offering negative or ultralow yields, European government bonds now offer yields that are more in line with long-term historic levels. Additionally, most managers believe that European corporates offer compelling risk-adjusted returns. New issuance in defensive and noncyclical sectors such as utilities, consumer staples, infrastructure, and pharmaceuticals offer attractive yields. There is also a preference for stable and mature companies with strong fundamentals and balance sheets that have recorded revenue and cash flow growth regardless of the economic environment and have also been able to pass on cost inflation to customers.
