Investors who are continuously on the ball in terms of monitoring the current market movements, by now have most probably tested their nerves due to the recent volatility, as market expectations of inflation have risen drastically.
As I have opined in previous writings, market expectations of higher inflation in the US are primarily brought about by the recent uptick in wage growth. Looking at the latest Federal Reserve minutes, the key message was one of confidence in economic growth and rise in inflation in 2018. Technically, this would imply a tighter monetary policy. This was the interpretation by the market on Wednesday evening, whereby the yield on the 10-year US Treasury tested highs of 2.953 per cent, the highest level since January 2014.
In reality, how will the trajectory of tightening policy effect investment grade and high yield bonds?
Investment Grade Bonds (IG)
In my view, there are other factors one needs to consider, rather than only looking at the impact of tighter monetary policy. Interestingly enough, credit spreads are relatively tighter compared to the start of the year. Following the recent movements, one would expect spreads to trade wider. I think that the surprise of IG spreads keeping well, is primarily brought about by the notable drop in the supply of bonds, primarily on the primary market, when compared to the previous year.
Undoubtedly, Fed rate hikes are negative for the asset class per se, and thus, market expectations of a faster trajectory might impact spreads. Having said that, the market still needs to re-assess inflation expectations. In addition, the preposition of more rate hikes than those expected by the market is as yet not crystal clear. In fact, if the Fed had to consider the possible negative effect of higher yields (higher borrowing costs) and their impact of economic growth, I believe they would re-consider their decision-making process.
My longer pick on IG bonds is in line with the possible upcoming opportunities, given the expected volatility. I still believe that the benign economic growth is supportive for companies and their finance servicing.
High Yield Bonds (HY)
In line with the recent volatility we’ve seen over the past days, a sell-off in risky assets, including HY bonds, was warranted. However, the interesting fact is that the spill-over effect on HY credit was quite contained. I think one of the reasons for the contained correction is more in line with investors’ perception that HY credit names are fundamentally stronger than before, and thus, in reality, market participants are unwilling to let go of their coupons.
My longer vision for HY bonds remains positive. I have repeatedly stated that from a specific risk perspective, selective HY credit have restructured their balance sheets over recent months and are now much more flexible to manage their business model.
In addition, despite the fact that many might believe that spreads are expensive, I still have a constructive view that selective companies are still offering attractive yields. Furthermore, given the strong underlying fundamentals going forward, we should expect a healthier market, whereby spreads should continue to narrow.
A word for those investors who only believe that markets solely follow theory: within the fixed income space, higher interest rates should negatively affect bond prices. However, history has shown that HY performed well in rising interest rate environments, given the economic pick-up and thus, a lower probability of default risk.
In conclusion, if investors diligently select good credit stories and unlock value, they will still fulfill their objectives from the fixed-income asset class, despite the current volatile markets. At times, opposing market direction might hurt in the short-run but outperform and reap dividends over a longer period.
Disclaimer:
This article was issued by Jordan Portelli, investment manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.