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Fixed Income Monthly - March 2023

Introduction

The bond rally since the beginning of the year has abruptly changed course as persistent inflation forces market participants to change their outlook on the path of interest rates. For the US Federal Reserve (Fed), the market’s expectations of a policy U-turn towards easing have been pushed out to early 2024, having initially priced in a pivot towards the back end of 2023. In this vein, at our recent Fixed Income Spotlight event, over 60% of our polled audience thought the Fed would pivot and cut interest rates in early 2024. There is a strong chance that the central bank may be forced to pivot earlier than this, perhaps in Q4 2023, on the back of the rapid tightening in credit standards which could begin to take a significant toll on the real economy. Refinancing is becoming increasingly expensive for companies and rising interest rates are already having a detrimental effect on the residential mortgage market, as well as auto loans. With the Fed funds rate now at 4.75%, the terminal rate is now priced at 5.50% by September. Empirically as we approach the end of a hiking cycle, this is normally the time to gain duration exposure: government bonds typically outperform higher-risk asset classes at this point in the cycle.

At the same Spotlight event, over 70% of our polled audience indicated a preference for investment grade (IG) bonds as their preferred fixed income exposure in 2023. Case in point, the value proposition for euro IG credit remains attractive, both on an absolute and relative basis. Spreads for the asset class currently price in a lot of bad news and remain relatively cheap versus history, while higher all-in yields make the risk-reward of euro IG, relative to other asset classes and regions, increasingly compelling (especially when hedging back to USD). From a corporate health perspective, euro IG fundamentals are holding steady for now. However, expect some degradation in the credit quality of certain sectors and names as the fallout from a higher ECB refinancing rate weighs on corporates. Nevertheless, careful selection remains with a preference for the highest quality companies with strong liquidity positions and healthy balance sheets, as well as those that are likely to benefit from fiscal support.

Alternatively, consider recession proofing via bonds with asset security. Our analysis shows that sterling denominated investment grade asset-backed credit outperformed straight corporate credit both during both the Global Financial Crisis of 2008 and the COVID-19 sell-off in March 2020, providing some ballast relative to straight corporate bonds. It is important to note that structured credit markets have been dramatically reformed since collateralised debt obligations (CDOs) wreaked financial havoc in 2008, with strict standards now in place to help protect investors and maintain market liquidity.

Meanwhile, inflation linked bonds could still provide a compelling investment opportunity despite easing inflation in recent months. On valuations, real yields have risen substantially over the last 12-18 months. Today, the nominal return on a 10-year US TIPS would amount to +1.4% per year plus US CPI, which is not bad in our view. We simply do not know where inflation will end up, so why not take out some inflation protection while it is relatively cheap to do so.

Steve Ellis
Global CIO Fixed Income

The Fixed Income Monthly provides a forward-looking summary of the medium-term views from the Fidelity Fixed Income team.

Strategy summary
Summary of returns as of 28 February 2023 (%)
Macro and Rates Overview
Inflation-Linked Bonds
Investment Grade Credit
High Yield
Emerging Markets
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