21 Jun 2023
2022 was a turbulent year for investors and fund managers across the board and, as an asset class, fixed income sold off sharply too. War in the Ukraine, an energy crisis, and a coronavirus hangover saw many funds struggle to reach benchmarks and often failed to remain in positive territory.
However, in such a difficult period, M&G’s Eva Sun-Wai, portfolio manager on the M&G Global Government Bond strategy and the Global Macro Bond strategy, has been telling IFA Magazine just how her team has managed to swim against the tide and still come out on top.
Eva spoke with IFA Magazine’s Sue Whitbread, explaining why she believes that the easing economic headwinds mean there are distinct opportunities in fixed income investing. In this Q&A, she highlights how and why M&G have used their position to capitalise on those opportunities which did present last year and also why she believes that fixed income now represents a very attractive prospect for investors.
IFA Magazine: Do you believe that 2023 will turn out to be a good year for fixed income investing? Can we go so far as to suggest that it is the return to favour of bonds or not?
Eva: “We’re positive about the outlook for the sector, yes. Of course, 2022 was a brutal year for fixed income. Central banks embarked upon their hiking cycles globally after a period of coordinated loose monetary policy to combat the pandemic. Whilst it is hard to time when those hiking cycles come to an end, the starting point for fixed income is now much more attractive. We are starting to see signs that higher interest rates are feeding through into the real economy. Central banks are still battling high and sticky inflation, but with worries of liquidity in the banking sector and tightening credit conditions, markets have accelerated forward their expectations of pivots from policy makers.
“We must also look at pure valuations. There are virtually no bonds out there that are yielding negative values in the corporate space. We're seeing investment grade corporate bonds yielding similar levels to equities, if not higher. Why would you take on equity risk of a corporate when you can earn the same return through exposure to a lower risk part of the capital structure? Given those yields are driven by a combination of high underlying risk-free rates and the corporate risk premium (the spread), even if spreads widen we are somewhat protected by the natural hedge that occurs from the risk-free element; a relationship that broke down during 2022, but looks much more compelling now.
“Despite high and sticky inflation, many of these yields also look appealing on an inflation-adjusted basis (real yields), not only in some developed markets (e.g. US TIPS) but also in some emerging markets (EM). Many EM central banks began their hiking cycles prior to their developed market counterparts. Historically, it has been the other way around. As a result, many EM central banks have been ahead of the curve when it comes to controlling inflation. Consequently, real yields in local sovereign bonds in those areas, especially Latin America, have, in our view, become more appealing.
“2022 was a unique year, and the invasion of Ukraine naturally meant sentiment for EM debt as an asset class was poor, which drove valuations cheaper. Despite sadly not necessarily seeing a resolution to the conflict in the near term, those valuations are now compensating for political, geopolitical and global macro-economic risks a little bit better.
“Across the board, we're just seeing much cheaper valuations in fixed income. Even cash-type products have re-emerged as an asset class. Whilst timing is difficult, compared to 2022, valuations are looking much more attractive and that throws up really interesting opportunities for bond fund managers.”
IFA Magazine: Are you seeing much risk in valuations at present and how do they compare to a year ago?
Eva: “Given current valuation levels, even if you are still cautious on duration and if you're still cautious on the trajectory of central bank hiking cycles, current entry points provide much more of a cushion. Even if you put your money in short-dated U.S. Treasuries, you're getting paid 4% to 5% yields to do so. Earlier this year, we saw 6-month T-Bills surpass the 5% mark and also surpassing the earnings yield on the S&P 500. Obviously there is a duration mismatch there, but as these are traditionally seen as a risk-free asset, it feels like you're getting paid pretty well to position portfolios defensively at the moment.
“On the other side of that, we are also seeing corporate bond issuance come back, default rates low and corporate fundamentals quite strong. Overall yields are still attractive in the corporate space, but we are starting to see some jitters in the banking sector and other cyclical areas, with spreads having widened post the rally we saw in Q4 2022.
“As mentioned, at the basic level, corporate bonds are composed of the underlying risk-free rate, plus a corporate risk premium. The difference compared to the pandemic, was that those yield increases were driven almost entirely by the credit spread element. That was because central banks were then cutting rates to support the economy. This time around, it's much more heavily driven by the underlying risk-free rate as spreads rallied towards the end of last year.
“Obviously, questions remain as to whether or not a recession will materialise but, in general, non-financial investment grade corporates, especially in non-cyclical sectors, seem relatively well positioned. I am in the camp of believing we will get a hard landing, especially in the US, given the stickiness of inflation and the tightness of labour markets, thus I favour government bonds to corporates against this backdrop, but there are opportunities to pick up extra carry from credits that can successfully weather the macro storm.
“Given that, last year, the Ukraine war and its impacts dominated the narrative and global geopolitics generally, I think this year it's more about diverging monetary policy: it's more about idiosyncratic risks and idiosyncratic opportunities but there’s certainly a lot of appeal for the asset class.”
IFA Magazine: You certainly seem pretty positive. Where are some of the key opportunities you’re seeing across the fixed income asset class at the moment?
Eva: “Yes, across the board you're well cushioned at this point. We particularly favour the front end of government bond curves. With inverted yield curves in US Treasuries, UK Gilts and German Bunds it makes sense to at least come back to neutral or position for curve steepening in short-dated sovereign bonds vs the belly of curves. We are favouring both shorter-dated because of the outright yield, but also longer-dated because of the higher convexity you get at the long end.
“If we do get a central bank pivot, the whole curve will rally, in which case you want the movement of the steepening trade from the front end, but you also want the convexity from the long end. Having said that, within the G4 we don't like Japanese duration, where real yields are low and the central bank continues to be dovish vs peers. A widening of the yield curve control band in December saw the curve sell off somewhat, but we are still heavily underweight given valuations as well as the potential for further policy exit from the BOJ. We do however like the JPY as a currency-play, given the extreme sell-off we saw last year. Now, we believe that not only are valuations attractive, but the currency would likely benefit from both further YCC exit, as well as a hard-landing scenario in other developed markets given its safe-haven reputation.
“Markets are forward looking. We tend to find that in areas where markets expect the central bank to hike, the currency becomes more attractive given the expectation of higher carry. For example, we like Mexican duration at the moment as local real yields are attractive, but we're less keen on the currency and can hedge this out using forwards, given it is now screening as expensive and has largely priced in the central bank hiking cycle.
“On the flip side, we like some Asian FX plays given the opposite dynamic. The region is generally behind on hiking cycles (albeit they are more insulated from the inflationary pressures that have gripped other regions) and they've benefited and are continuing to benefit from the China reopening story.
As mentioned previously, we also like inflation linked bonds. Long dated US TIPS are currently yielding 1.5% on a real basis, and given the data proving sticky inflation, breakevens look too low.”
IFA Magazine: Why would you argue that M&G is particularly well-placed to source these opportunities?
Eva: “Put simply, M&G is a market leader in the fixed income arena. We have one of the largest credit research teams in Europe that are vital to our bottom-up research and stock selection, covering corporates, financials and asset-backed securities. We also have an experienced dealing team who are fundamental to successful trade execution. We also have a huge range of fixed income products available to investors, from strategic flexible funds to ESG-focused high yield funds. Putting this together means that, as a team, we have the resources to execute the market and economic views that we have very efficiently.
“As fund managers, we have full autonomy in our decisions, but we also benefit from a lot of visibility, open discussions and idea sharing. As you’d expect, there are many different perspectives across those of us in the fund management team. This means we benefit from those different perspectives, the different ideas, as well as a great sense of collaboration towards efficient asset allocation and stock selection decisions. Overall, in the wholesale fund management team at M&G, we have 17 fund managers as well as investment specialists and fund manager assistants.
“Because of this strength and depth, as a house, I’d argue that M&G is very well placed. That is also backed up by a sound, long-term track record of performance. In fact, the first unit trust in the UK was created by M&G in 1931. Fast forward to now and you can feel on the desk that the team are genuinely excited about the prospects for fixed income - and that’s not just because we’re fixed income fund managers. It’s in relative terms as well as absolute.
“Despite 2022 being such a torrid year for the asset class, we performed strongly compared to our respective benchmarks and peers. Many of our fixed income funds outperformed their respective benchmarks by anywhere between 2-5%. I’d hope that this indicates to advisers and their clients that not only can we hope to outperform on the upside but also protect on the downside too.
“Finally, we have coverage on most areas of fixed income from a fund perspective. So whatever advisers and portfolio managers are looking for, we are well placed to provide an effective solution.”
IFA Magazine: What would you say to advisers or portfolio managers considering the fixed interest allocations in their client portfolios at present?
Eva: “I’d say that fixed income, in my opinion, should definitely have a place in portfolios at present, especially relative to other asset classes where the yield for a much lower risk of capital structures is very compelling. As we’ve already discussed, M&G is very well placed to source these opportunities across asset classes and geographies as well as offering an extensive fund range with a strong track record.
“I’d conclude by saying that, whilst 2022 was quite scarring for fixed income, especially in the UK given what we saw with the LDI crisis in gilt markets, I believe it remains important to stay diversified within fixed income, but at the same time to acknowledge that valuations are at some of the cheapest levels in over a decade – and in our space, markets can move very quickly.”
Author: Eva Sun-Wai
The views expressed in this document should not be taken as a recommendation, advice or forecast.
The value of the fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested. Past performance is not a guide to future performance.