295. Recession, rates and rebalancing – predicting the fixed income landscape in 2024

21 December 2023 (pre-recorded 11 December 2023)

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[NTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. Today’s guest gives a comprehensive overview of the opportunities available in fixed income markets and how that translates to positioning a strategic bond fund for 2024.

Chris Salih (CS): I am Chris Salih, and today we’re joined Alex Pelteshki, manager of the Elite Rated Aegon Strategic Bond fund. Alex, thank you very much for joining us today.

Alex Pelteshki (AP): Thanks for having me.

CS: No problem at all.

[INTERVIEW]

CS: I’m going to throw you in at the deep end here and ask the the golden question straight away. So, the UK as an example, we’ve got fears about lots of people losing a lot of their disposable income next year as rates remain at these levels and mortgages are sort of renewing at a lot higher rates.

Let’s ask that golden question: do you believe rates and yields have peaked? Do you think they’re going to fall and does it vary by region and cycle? Just give us a couple of minutes insight on that, please.

AP: Sure, absolutely. Just to go straight to the answer, yes. Yes, we do think rates have peaked. We certainly do not see any more rate hikes on the horizon across the major markets that we looked at, including the United Kingdom. This is our base case and this is primarily drilled by the fact that monetary policy is already quite tight, so, in other words, interest rates across Europe, the UK and the US are tight, and they’re restricting economic output and they’re having an impact.

Like you said, the speed with which that travels through the system varies to different degrees across those three different markets primarily because of the differences in the so-called monetary transmission mechanism. But in simple terms, you are already seeing the impact in Europe and in the UK in the form of falling house prices already, economic activity slowly grinding to a halt and a gradual uptick in unemployment across both Europe and in the UK, and in the US you are seeing tentative signs or early signs of this already beginning to happen as well. So, from that point of view, if you already have base rates above 5% – so interest rates above 5% in the US and in the UK – and above 4% in Europe, the main goal of that journey was to combat inflation. And if you look at those three markets, now for the first time in 18+ months, headline inflation levels, both or across the US, the UK and Europe are already below the base rate of the central banks.

So, in other words, monetary policy is already above inflation. So, we certainly don’t expect to see more hikes so to say. And then we can probably start hoping or thinking about rate cuts down the line at some point.

CS: Is it hard to make any call on rate cuts at this stage? Because the general view is that they’re quite stubborn and want to hold them for longer. I mean, do you have any view? Do you think the bite will just be too much, particularly in the UK and Europe where we don’t have those 30-year mortgages like the US perhaps has?

AP: We think in particular the Bank of England will want to see a sustained progress towards their inflation goal in order for them to start talking about cuts. They will be very cautious about any premature easing of monetary policy, but it is very clear that monetary policy is restrictive as it is. So towards the question is, it’s a matter of when we’ll start seeing cuts rather than if, and we don’t have a perfect answer to be honest. So, we’re not here to time the market, but we are certain that we will see a lower base rate at some point 18 months from now – and I say 18 months because it’s a sufficiently long period of time, and in reality it could happen much faster.

CS: Okay. We’re hearing a lot from managers at the moment about increasing government bond exposure. Is that something you are making use of in this strategic bond fund and if so, does it still represent value at these levels?

AP: Absolutely. We, as you know, manage a strategic bond fund which is very flexible and invest across the entire bond universe; this is from government bonds to investment grade, high yield to emerging markets, and we currently find government bonds offering very attractive value in certain points of the yield curve. That is to say, we’re quite happy to increase government bond exposure in the short maturities anywhere between three and seven years government bond maturing within that period. We are not certain that adding government bonds maturing in longer than 15 or 20 or 30 years from now is still a good value. So while we do like government bonds in general, we still expect the so-called interest rate curve to steepen, therefore we find quite a bit of value in the front end, but not so much in the long end.

CS: Okay. Beyond government bonds, are there any other parts of the bond market that you are particularly keen on at the moment?

AP: Yes, absolutely. If you look in general, we think the bond market looks as attractive as it has in many years relative to most other asset classes. In the very simplest terms, fixed income as an asset class is something or was something traditionally there to provide income sitting investors with exactly that, with recurring source of income with very low capital at risk so that you don’t have to risk your savings too much and with quite a bit of liquidity. So, you could withdraw cash essentially tomorrow if you wanted to, if those were your circumstances.

And in the past 15 years this has all disappeared from the fixed income market, because of the global central banks and bond deals at zero or below zero. And now in the past 18 months, that value has returned to fixed income in general. And if you think of it, in its simplest terms, fixed income now yields more than equities. If you only look at the investment grade bond market, it yields more than the yield on the global equities, if you look at the S&P 500. So, as an investor, you no longer need to chase that additional income or that same amount of income in riskier assets like equities, you can move the money back to bonds and that’s a very powerful proposition, it’s one that you haven’t seen in over 15 years.

So, if you look at all-in yields – purely only investment grade, you don’t have to go on anything riskier – you are starting from over 5.5% yield on the index in the US right? And if you look in the high yield markets, then that yield becomes 9%. So, those are owning very attractive levels that we think are probably a once in a generation opportunity that investors should make use of.

CS: And let’s just be clear on that because one of the follow ups – we’ll have a few follow ups from what you’ve just said there – but the main one is, you know, in the past few years when there have been opportunities in fixed income, they have been quite fast and quite sharp, particularly, you know, the likes of Covid. Obviously this environment’s slightly different. Is the opportunity as attractive now as it was, say, six months ago?

AP: Absolutely. The opportunity is as attractive as it was six months ago, we don’t necessarily bank on it, it’s a very short window of time that it will disappear tomorrow. Certainly not in the same speed of time that it happened during Covid, but we absolutely are of the opinion that right here, right now, bonds are very attractive. And I go back to the illustration I provided you [with]. If your alternative is chasing lower amount of income – or yield – and going into riskier assets that are equities, and you still don’t have to do that: you are picking up plenty of yield buying investment grade bonds versus your equity allocation, so absolutely.

CS: Okay. Well, let’s talk about that as well then because you mentioned there, obviously government bonds have an attractive yield at the moment. You are an active portfolio, you’re a strategic bond manager. Let’s talk about a couple of the other areas perhaps where you are adding value. So, maybe first talk about corporate bonds and give us some insights into what you’re looking at in there and then we’ll talk about high yield after that.

AP: Absolutely. So, corporate bonds – looking at the investment grade market – we think that the European corporate bond market offers excess opportunities. There is in other words, a lot of fear priced into credit spreads. We definitely think that the economy is slowing down, is already slowed down in certain parts of Europe, but we see a lot of default priced in the investment grade bond market. And as an active bond investor, this is what your paid to do; you’re paid to evaluate whether you’re overcompensated for taking those risks. And we think that’s the case in Europe. We find the market quite attractive, in particular when we compare that to the US investment grade or US corporate bond market.

So, all in, we have a preference, the risk-adjusted reward or I guess the opportunity cost is better into corporate bonds versus high yield, but we certainly are not shying away completely from the high yield market as well, just because the starting yield there is so, so attractive. So if you have a high yield index touching 9%, it really needs to sell off a lot in the following year for it to be loss making. The difference is that there will be a lot of dispersion this time around, in particular in the riskier part of the universe. Therefore we’re shying away from riskier borrowers, anything below B- and in particular CCC we’re not keen on, we’re focusing on high quality, high yield borrowers, BB area. We think it’s a sweet spot where you can still generate … we can find bonds offering the 10% yield, which we think is very powerful.

CS: I think it’s being overlooked a bit, hasn’t it, the high yield market because there’s quite a lot of dispersion in terms of views on the high yield market. So some people see it as quite a risky market with companies now being forced to renegotiate their loans, et cetera, at a lot higher levels. But, by the same token, the high yield market is very different to what it was 10 years ago in terms of construction, there’s a lot more high quality companies in there.

Is it all about being active in that space now? Because high yield 10 years after the credit crunch was very much, you could make money quite easily there, it was one of the big winners. Is it now just about being a lot more selective in high yield?

AP: I think you said it exactly right. The point now is that first, the high yield index is much, much, much better quality versus what it was 10 years ago so the proportion of say the lowest credit or CCCs or below is much lower and the proportion of BBs, which is the highest end of higher market is much higher. So the quality is better to begin with, which naturally limits how much the index in general can sell off or can move wider.

Your other point about being selective is exactly right as well. If you are a corporate that is say B or CCC-rated, you need to refinance in this market with yields north of 15%. Now if we start talking about your capital structure and you have to pay 15-20%, this becomes an extremely difficult business to run. And so we are very, very sceptical or very cautious lending money in that part of the market. But at the same time, there is a lot of quality in that market in the BB area of big capital structures with long history of being in the markets, of producing real strong cash flows. And those parts of the market can still offer you opportunities where bonds yield 9%, 10% and we think this is an excellent opportunity.

So you really have to differentiate between the different spectrums of the higher market, but our view is that whoever is waiting for a global financial crisis type of event and spreads blowout to that level to get back into the market, they’ll miss out on the boat.

CS: Okay. Next one. This is one that’s perhaps quite an interesting one to explain why more so than which. Short or longer-dated bonds — should investors have a preference at this stage in the market?

AP: That’s a very nuanced question and the very nuanced answer to that question, I would say, in certain parts of the government bond markets, you are not paid to be taking on additional duration risks or investing or lending down the curve. In other words, the curves are too flat and you’re not paid, we don’t think you’re compensated for the term premium down the line. So we definitely favour the front end.

In corporate bond markets, we think it’s a bit more nuanced or a bit more mixed. There are still places where the entire credit curve is quite wide. And granted, even though it may look flat, if you are confident that you are lending to a quality borrower, over time you expect that entire credit curve to shift downwards, and even if it’s a parallel shift of say hundred basis points between the front and the long end, the effective duration makes it more attractive for you to invest in the long end. So I would say in short government bonds, most likely the front end is better; in corporate bonds it could be quite mixed.

CS: Okay. Last couple of questions, geared more towards the future. Well in a nutshell, are we facing a recession in 2024? But on top of that is that, well, obviously it’s a bad thing for the economy, but for your portfolio, does that open up a number of other opportunities once again?

AP: Right, let’s tackle that one. Right now, we are witnessing negative growth in certain parts of Europe, in particular the ones focused in the manufacturing sector, so the core. But some periphery, which is more service-oriented is doing okay. So, there is a reasonable chance that there may be a recession in Europe, but also there is a reasonable chance that Europe may avoid that. And you could probably construct similar arguments for the UK as well.

If you were to say the likelihood of the UK entering into some sort of recession in the next 12 months versus not, is probably higher by a little bit, but <inaudible> we don’t see periods of a very deep recession, a very structural and profound recession either in Europe nor in the UK, let alone in the US.

So, to us, it becomes more of a question of where do we expect economic growth to peter out? And if it’s around -0.5%, so small recession, to +0.5% on aggregate, that kind of environment that you alluded to is very favourable for fixed income in general. So, even though the definition of being in the recession or not, and the different scenarios would differ, the overall opportunity will be for us pretty much the same because a situation where inflation is falling but growth is relatively anaemic or just below trend, is something where bonds would particularly like.

CS: Okay. Well given you’ve said that then, I mean 0.5 to -0.5 possible recession, if there is one, it’s very mild versus sort of, you know, small bit of growth. How are you positioned in that scenario going into the new year? So give us an idea of how your positioned for that type of environment.

AP: Absolutely. So, positioning is all relative to also what’s priced within the markets. So starting from corporate bonds, as I mentioned, we are overpricing the recession within markets or overpricing the recession probability within Europe, so we favour European corporate and high yield bonds over those in the US.

Relatively, we have more risk in investment grade versus high yield. But within high yield, we certainly don’t shy away. Particularly, from a point of reference, our fund can invest between 0 and 40% of the assets in the high yield market, and at this point we’re about 27%, 28%, so we’re a little bit more than half [CS: A decent amount in the market.] Yes, it’s reasonable amount. Yes, and all of that is concentrated, mostly concentrated as I mentioned in the BB part of the market. But we have more than half of, say, our opportunity set within high yields, so we are definitely not negative.

On the government bond side, given our starting premise is that we don’t expect any more rate hikes and we’re probably opening up the opportunity to some rate cuts because of the trend of lowering inflation across Europe, the UK, and the US, we wouldn’t be surprised to see some, if not all of those three central banks, somewhat reducing the level of base rates. Therefore that would be a tailwind for government bond markets, as well in particular, the front end of the curve.

So, if I was to summarise our positioning, it’ll be long duration versus our historical ranges in risk-free markets and risky assets; we favour investment grade over high yield, but we certainly are not shying away from taking risks in high yield as well.

CS: Alex, thank you very much for joining us today.

AP: My pleasure.

SW: The Aegon Strategic Bond fund has a very broad and flexible remit. It invests globally and is a true strategic bond fund that can change its positioning very quickly when necessary. To learn more about the Aegon Strategic Bond fund please visit fundcalibre.com. And don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts.