A New Chapter for Fixed Income
2022 was a challenging year for nearly all publicly
traded asset classes, as central banks increased interest rates aggressively to tame inflation in a complex macro environment. Broadly speaking, traditional government and corporate bond strategies provided little protection and most investors experienced
negative returns from their fixed income and equity allocation simultaneously. RPIA’s alternative fixed income strategies were able to avoid significant drawdowns experienced in traditional strategies and add significant value for our investors.
As we approach the end of the rate hiking cycle, we strongly believe that now is the time for allocators to be adding to high-quality fixed income. On an absolute basis, bond yields are greater than they have been in many years, which means investors
get paid to wait with a wide margin of safety if rates were to continue to rise. On a relative basis, the risk-reward of fixed income appears superior to both equity investments and traditional alternative assets such as real estate and private assets.
BBB-rated bonds are now offering the same yield as real estate cap rates (which have historically offered a premium) without sacrificing liquidity. The return available from publicly traded investment grade credit also compares very favorably to historic
returns from lower quality private debt portfolios. Investors can benefit from the transparency of knowing that bonds have repriced to fair value (“mark to market”) compared to a more opaque private debt portfolio. The relationships exhibited
between dividend yields, cap rates, and fixed income yields all suggest an attractive proposition for investors to increase fixed income allocations.
Looking forward, we think that the markets will remain volatile in 2023 as central banks continue to tighten financial conditions and the implications for asset valuations and the real economy remain uncertain. Although we are in the early stages of a
recession, corporate credit fundamentals in many areas remain sound as issuers took advantage of the low funding costs in 2020 to refinance existing debt, making them well-prepared for an economic slowdown. At this juncture, we believe that active
management is crucial for navigating the market as the year unfolds to create diversified returns for investors while also prudently managing risk.
Below are 5 charts that sum up our takeaways from 2022, as well as our outlook for 2023. We hope you will find them thought-provoking.
Please feel free to contact us if you would like to discuss further or learn how we can help you meet your investment objectives.
1. Light at the End of the Tunnel
Historically, investing in advance of the final rate hike has generated strong returns
Sharply rising interest rates in 2022 meant the worst return for bonds in a century; however, we believe there is an opportunity going forward. Market pricing implies we will reach the peak overnight rate this cycle in mid-2023. Historically, investing in the bond market approaching this final interest rate hike has been a profitable strategy for investors.
2. Balancing Yield and Liquidity
Bonds can provide a yield competitive with real estate cap rates for the first time since the Global Financial Crisis
Over the last decade, investors moved away from traditional fixed income as part of the search for yield. A popular substitute for fixed income was real estate, with cap rates 2-3% higher than the yield offered by BBB-rated corporate bonds. With the
interest rate increases of the last 12 months, we believe investors can now capture a yield on bonds that is basically the same as the cap rate on a real estate investment, but without sacrificing liquidity.
3. Credit vs. Equities
Bonds are the cheapest they have been to equities in 20+ years
The historical relationship between bond yields and the earnings
yield of equities is 2-3 standard deviations away from the average. That is to say, from an income perspective, bonds are positioned much more favorably than equities. This disconnect has been driven by the dramatic increase in short-term interest
rates, which means bond yields fall in the short-term, but could set the stage for higher returns in the long-term.
4. Issuers Prepare for a Slowdown
Corporate borrowers have reduced leverage, meaning they are better positioned for a slowdown
Since the COVID-induced market crisis of 2020, corporate treasurers at both Investment Grade (IG) and High Yield (HY) rated companies have reduced leverage. In addition, many companies took advantage of low funding costs to extend maturities and
refinance upcoming debt issues early. As such, corporations, particularly IG-rated ones, are heading into a period of slowdown well-positioned to weather the storm.
5. Better Opportunities
More dispersion in credit spreads means more opportunity from active management in Canada and the US
Given the mounting evidence of economic recession in the past year, credit spreads have widened across various markets and sectors. In addition, the spread differentials between issuers within the same sectors have also
increased significantly. This wider range of valuations across the board can indicate more opportunities for an active manager to find relative value in corporate bonds through the security selection process.