Ingredients in the mix for a more appetising 2023
Jim Cielinski believes 2023 should bring relief on rates as central bankers recognise their servings of policy tightening are dampening inflation
Comparing carbon emissions in US and European CLO portfolios
The pain caused by rising yields has arguably been frontloaded, creating attractive entry points
did you know?
We believe bonds should regain their traditional role as a diversifier
The damage caused by tighter financial conditions is likely to weigh on corporates, demanding a selective approach
Bear-case scenario most likely as recession risks loom larger
ESG trends in leveraged loans
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The changing role of bonds, Jim Cielinski, Global Head of Fixed Income
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Why the Credit Cycle Matters More and More
Following the cycle path: update on the latest credit risk indicators
Bear-case scenario most likely as recession risks loom larger
We believe bonds should regain their traditional role as
The damage caused
by tighter financial conditions is likely to weigh on corporates, demanding a selective approach
Multi-asseT credit: 2023 could be a year of two halves
High quality bonds are primed to bloom in 2023
Read the full article for more analysis of how sticky inflation is likely to be
Andrew Mulliner, CFA
Head of Global Aggregate Strategies | Portfolio Manager
Anyone who has made a béchamel or white sauce will recognise the dilemma facing central bankers. At first the combination of milk, butter, and flour remains a runny liquid. You stir over the heat, but it refuses to thicken. So you add more flour. Nothing happens. You add more flour. Still no response. The temptation is to keep adding flour, but there is a risk. The compounding effect of all that flour, together with the heat, creates a reaction, and all at once the sauce turns far too thick and lumpy.
Central bankers’ policy tightening is the flour and the transmission mechanism (how that tightening feeds through to the economy) is the heat. The outlook for the global economy in the year ahead is lumpy as tighter financial conditions provoke material growth slowdowns and recessions. Yet, for many parts of the fixed income market, 2023 could prove to be a far more appetising year.
Head of Global Aggregate Strategies
“The pain in fixed income markets has arguably been frontloaded, much like the US Federal Reserve frontloaded its interest rate hikes”
Figure 1: US inflation and interest rate history
Too hot to handle: dampening excesses in the economy
The past year was unpleasant for fixed income as inflation soared and the distortions to asset prices created by quantitative easing unwound. As central banks stepped back from repressing yields, price discovery returned. Bond yields rose sharply, producing some of the worst total returns in the history of fixed income (1).
Yet, the pain in fixed income markets has arguably been frontloaded, much like the US Federal Reserve (Fed) front loaded its interest rate hikes with consecutive 75 basis-point increments. We should not expect the same in 2023. The starting point of higher yields and wider credit spreads should offer a healthier outcome for bond investors.
How central bankers calibrate monetary policy to control inflation without causing too much economic damage will dominate markets and we can expect market volatility to persist around their announcements. Previous inflationary episodes are instructive. As Figure 1 shows, the fast pace of US rate hikes in 2022 has only previously been seen under Fed Chairmen Arthur Burns in the mid-1970s and Paul Volcker in 1979 and 1980 – both periods of rampant inflation.
Source:Bloomberg, FRED, 31 January 1960 to 11 November 2022. Federal funds effective rate %, PCE = Core Personal Consumption Expenditures Price Index inflation (excluding energy and food) year-on-year (YoY) % change, CPI = Headline Consumer Price Index inflation YoY % change.
Authored by the Global Structured Debt Team, who are led by:
Two things are worth noting:
Both Burns and Volcker began easing when the economy weakened only to raise rates again when inflation remained high. This may incline today’s Fed to retain rates at a high level to avoid repeating this mistake.
Rates have historically not peaked until inflation moves below the fed funds rate.
So while we expect the Fed to slow the pace of hikes and pause rate increases in coming months, a cut will have to wait until inflation moderates significantly.
For these reasons, and because we expect the US economy to outperform most other developed market economies, we think the Fed will remain tough on tackling inflation. In Europe, the European Central Bank (ECB) and the Bank of England (BoE) may pause their tightening earlier, but even there a resolute focus on inflation will likely keep the hawkish rhetoric flowing for longer than the economies can tolerate.
Sticky business: will inflation recede?
Several factors kept inflation stuck at a high level in 2022, including supply chain problems, the Russia-Ukraine conflict and, in the US, the pass-through of shelter costs in the Consumer Price Index. These should fade, with goods prices leading the decline and base effects making it hard to sustain high year-on-year inflation numbers. We expect inflation in the US to soften but remain above the Fed’s target 2% rate. Europe’s reliance on imported oil and gas aggravates the inflation outlook there, but progress in diversifying energy imports and reducing energy use mean further shocks would be linked to weather or geopolitics.
Global Head of Fixed Income
(1) This outlines a global standardised framework to measure GHG emissions from private and public sector operations.
Multi-asset credit: 2023 could be a year of two halves
Read the full article for the outlook on different fixed income asset classes
The challenge facing investors is deciding which part of the pool to swim in next year, as 2023 could become a tale of two halves, argues Head of Secured Credit Colin Fleury
Navigating the uncertain waters of 2023 requires some caution given that inflation is still running hot and central banks remain in a battle to tame it. In our view, policy tightening effects are yet to fully filter through to consumers and corporate performance.
Excess consumer savings in the US, for example, have dipped to lows post their pandemic boom, but spending is softening rather than rolling over. Third-quarter corporate earnings have held up better than expected. We are seeing only early signs of corporate headcount reductions or pressures being felt by individuals as they tackle higher debt service costs from a rising interest rate environment.
We have not yet seen the effects come materially through in the performance of the companies we invest in or the collateral pools of consumer credit or mortgages that back securitised assets. That is still to play out, with other risks to the global outlook such as China property sector and COVID challenges and the Russia-Ukraine conflict bubbling in the background.
Fundamentals are treading water
Given such corporate and consumer resilience, we are yet to see a material weakening in credit fundamentals, and markets are not fully pricing in the accompanying recession risk. Spreads have also been supported by an unusual supply-and-demand backdrop, with generally limited debt issuance in 2022. We believe that 2023 could become a tale of two halves, with spreads widening through mid-year as the economic reality of recession seeps through and more appropriately price recession risk.
We expect more clarity on the outlook to emerge later in the year. This could include more definitive signs that inflation is getting under control and a pivot from central banks away from policy tightening. Currently the US jobs market, for example, appears to not be cooling enough, given mixed data. Non-farm payrolls growth is starting to moderate, but average hourly earnings ticked up in the November 2022 release.
John Kerschner, CFA
Head of US Securitised Products; Portfolio Manager
Head of Secured Credit;
Figure 1: Mixed signals from US jobs market
Source: Refinitiv Datastream, Janus Henderson Investors, 15 November 2022.
Better yields, more inviting pools
A broad repricing of risk-free yields has made credit more attractive. Regardless of which investment pool you swim in, in our view, it feels sensible to start the year on the safer side. This may mean shifting portfolios ‘up in quality’ by, for example, looking at high-grade securitisation, such as AAA- or AA-rated collateralised loan obligations, and other more senior parts of securitisations in Europe and the US.
Nevertheless, the risk of further spread widening will have passthrough even to the high-quality end of the market. So, understanding how much recession risk is priced into spreads today is key for investors. In our view, high grade securitisations are pricing in greater recession risk than other credit markets, particularly as recent rallies on optimism about potential policy pivots (a pause or a slowdown in the pace of interest rate hikes) has seen spreads retrace from their recent wides, US high yield bonds being just one example.
“We are yet to see a material weakening in credit fundamentals, and markets are not fully pricing in the accompanying recession risk”
John Pattullo and Jenna Barnard, Co-Heads of Global Bonds, believe the confluence of attractive yields and an inflection point in rates should make 2023 an opportune year for high quality investment grade and government bonds
Every so often, ideal conditions present themselves. For the titan arum – the world’s largest unbranched flower – it can be anything between two to 10 years between blooms, but when it flowers, the results are impressive. We think high quality investment grade bonds, especially government bonds, are in a similar sweet spot heading into 2023, as a confluence of attractive yields and an inflection point in rates opens up the potential for strong returns.
Figure 1: Yields on government bonds
2023 is an inflection point
For bond markets, policy tightening in 2022 to tackle inflation was painful as yields rose. Yet the price correction lifted government bond yields back to levels not seen in more than a decade. It was a similar story with investment grade corporate bonds where both credit spreads and yields moved higher.
Attractive income levels on bonds, however, are only half the picture. We think 2023 will also be an inflection point for the rates cycle – as central banks shift their policy in response to declining inflation and an economic downturn. This means that while we like short-dated bonds, there may be an opportunity cost to holding only short-dated bonds and that is potentially foregoing bigger capital gains from holding longer-dated bonds as rates decline.
Bond yields have often overshot when core inflation spikes heading into an economic downturn. This decoupling of government bond yields from economic prospects occurred in late 2022 as bond yields rose despite manufacturing new orders declining (Figure 2). We expect government bond yields to recouple with the economic data. From above 4% in the fourth quarter of 2022, we think the US 10-year government bond yield could be close to 2% by the end of 2023. This could lead to strong capital gains on government bonds and should also have positive implications for better quality investment grade corporate bonds, since these bonds are typically sensitive to rate moves.
Source: Bloomberg, Janus Henderson Investors, Institute for Supply Management (ISM) manufacturing new orders, US 10-year government bond yield, 30 November 1972 to 30 November 2022.
(1) Source: Bloomberg, Janus Henderson Investors, ICE BofA US Corporate Index, ICE BofA 1-3 Year US Corporate Index, at 30 November 2022. Note. The calculation of the breakeven is the yield to worst divided by the modified duration. Basis point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%. Yields may vary and are not guaranteed.
Read the full article for analysis of why employment figures are likely to take a downward turn
The rapidity and magnitude of central bank tightening caused yield curves to flatten and invert, meaning that shorter-dated bonds are paying similar (if not higher) yields than longer-dated bonds. This is creating a rare opportunity for investors to earn a higher income from holding shorter-dated bonds than longer-dated bonds, while also being exposed to less interest rate risk
For example, at the end of November 2022, yields would have to rise by a further 282 basis points (a so-called breakeven) to wipe out the positive total return from shorter-dated US 1-3 year investment grade corporate bonds. This compares with a breakeven rise of 78 basis points for US investment grade corporate bonds in general (1).
“While we like short-dated bonds, there may be an opportunity cost to holding only short-dated bonds”
(1) ECB, June 2022.
(2) Janus Henderson Investors, April 2022.
Figure 2: ISM new orders versus US 10-year government bond yield
Past performance is no guarantee of future results.
Bond yields overshoot when core inflation spikes into growth downturns (circled)
Source: Bloomberg, Generic US Government Bond 10-year yield, Generic UK Government Bond 10-year yield, Generic Germany Government Bond 10-year yield, 1 January 2020 to 29 November 2022.
Yields may vary and are not guaranteed.
There is no guarantee that past trends will continue or forecasts will be realised.
Co-Head of Global Bonds; Portfolio Manager
Co-Head of Global Bonds; Portfolio Manager
ISM new orders 6m change
US 10-year yield 6m change (rhs)
Read the full article to find out how the carbon intensities of US and European CLOs compare
Getting a comprehensive carbon picture for non-traditional assets can be challenging. Head of Secured Credit Colin Fleury and portfolio manager Denis Struc look at climate-related risks in collateralised loan obligation (CLO) portfolios
The growing importance of assessing the carbon impact of investment portfolios is clear, with increasing ESG standards and reporting requirements globally. However, the scale of the challenges that need surmounting can vary greatly depending on the type of investments.
Gathering estimated emissions data for a portfolio of traditional equities or bonds in large global corporations is considerably more straightforward than non-traditional assets, such as a portfolio of loans to smaller and often privately-owned companies or securitised products. This is because a handful of ESG data providers have developed ESG scoring approaches and carbon emissions data capture that is typically focused on traditional asset classes.
A typical ESG data provider covers less than 5% of the secured loans market, as measured by the European and US Credit Suisse indices. We have therefore developed bespoke methodologies to estimate emissions from secured loans and corporate credit in general, which can then be applied to collateralised loan obligation (CLO) portfolios.
Such emissions are defined more generally under the greenhouse gas emissions (GHG) Protocol (1)
Head of U.S. Fixed Income
Bespoke approach to measuring carbon
Gathering reported corporate carbon emissions across many companies globally and grouping them into granular and representative peer groups forms the basis of our methodology in estimating emissions. This allows us to obtain a reliable average estimation of carbon emissions attributable to a well-defined set of sectors and sub-sectors.
Using estimation, we can then efficiently overlay carbon analysis on any portfolio with corporate credit exposure. As we continue our direct corporate engagement efforts, our estimates will gradually be replaced by reported carbon numbers from more companies, further refining our analysis.
“Using estimation, we can efficiently overlay carbon analysis on any portfolio with corporate credit exposure”
Accounting for carbon in CLOs
CLO transactions, being primarily comprised of portfolios of corporate secured loans, naturally fit the approach described above, allowing us to have an early and comprehensive view on the carbon make up of these investments.
The largest proportion of carbon emissions in CLO transactions are those related to the underlying corporate borrowers in the CLO collateral pools and are captured at the aggregate level in Scope 3 emissions. In this analysis, we focus on Scope 1 and 2 emissions of those underlying corporate borrowers, represented through the Weighted Average Carbon Intensity (WACI) measure. This information is then aggregated at each CLO overall portfolio level, thus representing Scope 3, or ‘financed emissions’, attributable to these CLO transactions.
Scope 1 accounts for direct emissions from sources that are owned and controlled by an organisation. These would include heating (fuel combustion on site) and company vehicles.
Scope 2 accounts for indirect emissions from purchased electricity, heat or cooling, which is used by an organisation.
Scope 3 accounts for all other indirect emissions, which are a consequence of the activities of an organisation from sources it does not control (i.e., emissions from downstream and upstream activities such as goods or services that are bought or sold, as well as ‘financed emissions’ attributed to investment portfolios of financial institutions such as banks and asset managers).
Read the full article for more on the different scenarios and which is most likely
Our latest scenario analysis does, however, highlights the more positive outlook for core fixed income
Welcome to the latest edition of our bond market forecast analysis. This report is based on the scenario analysis run by the Global Bonds Team to guide fixed income asset allocation decisions. Each report tries to assess the expected returns potentially delivered by the major fixed income sectors based on a range of modelled outcomes (see appendix for a full description of our methodology).
We adopt a scenario-driven approach to identify the relative attractiveness of fixed income sectors. Our aim is not to perfectly forecast returns to the nearest basis point (as that is not possible), but to understand the range of return outcomes and gauge the resilience of that performance across probable scenarios.
Our base case over the year to end of 2023 is that the global economy enters a recession. The speed at which central banks have hiked rates will feed through to the real economy including the housing markets, and consumer spending power weakens as real incomes are eroded by inflation. With tight labour markets, unemployment is not expected to rise as significantly as it did during COVID, but demand destruction results in weak GDP and falling inflation. Although stronger consumer spending stateside and the country’s lower sensitivity to energy price swings helps insulate the US from the worst of the downturn we model, we still expect the US to fall into a recession.
Various leading indicators have already signalled that recession is likely. A soft landing is still possible in the US, but the chances are receding. Overall, these two scenarios – recession and soft-landing – account for over 75% of the probability distribution. Inflation falls in all scenarios from current levels to between 1.7% and 4.5% in a year’s time.
Central banks remain laser-focused on current inflation
Across all four scenarios modelled, inflation has either peaked or will do so by early 2023, and fall back sharply from current levels, but to differing degrees. Broad money growth has collapsed (unlike in the inflationary 1970s when it stayed above 10%), supply/demand imbalances that pushed up prices are correcting (e.g. freight rates, used car prices), housing markets are showing price falls and the base effects of energy price rises should bear down on year-on-year inflation numbers (albeit with a longer lag in UK/Europe).
Forward looking indicators such as real money supply growth, PMI new orders, and the inverted yield curve point to a sharp downturn ahead, reflecting the lagged effects of tighter monetary policy. Inflation-linked bond real yields made new highs for this cycle since our last report, signalling a tightening of financial conditions. Ultimately, current central bank policy means more rate hikes until inflation shows a more pronounced downward trend, which will be met with demand destruction and a squeeze in real and discretionary incomes.
Figure 1: Fading money growth suggests inflation is heading lower
Source: Refinitiv Datastream, Janus Henderson Investors, 31 January 1965 to 30 November 2022. G7 Consumer Price Index, year-on-year % change, G7 Broad Money growth, year-on-year % change. G7 countries are Canada, France, Italy, Japan, Germany, UK and US. Broad money is the stock of physical cash, bank deposits, money market funds and other monetary instruments held by the private sector.
CFA Portfolio Manager
Client Portfolio Manager
Figure 1: Fading money growth suggests inflation is heading lower