believe these are the safest places to be if you are constrained in fixed income and credit. Nash: Markets did a bad job of pricing risk correctly during the quantitative easing years. Although it is a good economy, which is why the adjustments are occurring, will the default rate pick up because there is nowhere to hide? Evans: Covenant advisers are extremely busy with restructur- ings. I wonder if this has been caused by banks thinking it was not worth calling in money from zombie companies while interest rates were low and changing their view now that rates are picking up. It is too early to tell. Reedie: As financial conditions tighten, cracks will start to appear. Anything over-levered or exposed to the wrong part of the economy is going to be tricky. It does not feel like a systemic issue.
Freedman: Pricing power is always important, but even more so now with corporate margins coming under pressure. There has been de-leveraging through Covid and companies with too much debt could struggle. But I cannot see a material pick up in default rates. You could argue that credit spreads are back to their 400-basis point long-term average, but they could widen further. Also, if the marginal buyer is not there for investment grade in Europe and we see outflows because of concerns over the European Central Bank becoming more hawkish, it will impact spreads. Reedie: The tail risk is that it could become self-fulfilling. US investment grade’s total return is -5.5%. Once that gets in front of the holder who has always been long in fixed income and they start reading that this time it’s different, that could accel- erate in a dis-orderly fashion. This is the market participant angst we talked about. Clissold: Where do they go to hide? The S&P is down 10% and bonds 5%. Reedie: Global aggregate bond ETFs, which are short duration, yield more than 2%. Those are potentially places you can hide. Thomas: If you are moving out of high yield, you can go into emerging markets where valuations are attractive. Freedman: Fixed income markets are quick to price in rate expectations. Normally it does not take long, if you have kept your powder dry, until you can reinvest in higher yielding bonds and wider spreads. We may not be far away from that, perhaps in the second half of this year.
Because of geopolitics, if we get aggressive rate hikes they may ultimately take out rate expectations further down the line, and it would create some attractiveness on the shorter dated parts of the curve. Nash: That’s what happened. Treasury yields have risen about 60 basis points this year and South African rates have fallen about 60 basis points. That is the macro story. Are emerging markets solid now because the US yield curve is
22 April 2022 portfolio institutional roundtable: Fixed Income
flattening? The inflation story in the US means lower rates down the line, which will not fire up the economy. If rates are going to be lower, buy long-end local bonds. Is that the story, or is it a natural rotation from developed markets to emerging markets because the growth story is in place? I am not sure which one it is. Thomas: It is also about flows in emerging markets. They have not seen the flows they experienced around 10 years ago since people reduced their exposure as the commodity cycle unwound. So, the flows have been a headwind for years. But the valua- tions are compelling, and growth is solid. If the recovery is sus- tainable and synchronised, then emerging markets are an interesting proposition. Reedie: They are benefiting from their exposure to oil. On the flip side, geopolitics is getting more problematic. The bull case for emerging markets has been in place for a while and those
The steeper the hiking cycle
the greater the volatility. Lloyd Thomas, Border to Coast Pensions Partnership
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