Famous Last Words: Can 2023 Be Any Worse Than 2022?

Introduction

It has certainly been a year to forget for fixed income investors. Not only have investors suffered some of the worst total returns in history, but they have also had to deal with the impact of the highest correlation to equities that we have experienced in history (Figure 1). It was also a rare year in that both interest rate and credit components of credit underperformed in unison (Figure 2).

Figure 1. Correlation Between Bonds and Equities in 2022 Was Unprecedented

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Source: Bloomberg, NBER, Morgan Stanley; as of 31 December 2022.

Figure 2. Credit Total Return Contributions – Rates and Spreads (1998-2022)

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Source: Deutsche Bank, ICE Indices; as of 31 December 2022.

Despite the gloomy year, most sell-side research seems to give an optimistic outlook for credit markets in 2023. Such positivity always makes us pause – especially since in this instance, we would concur that there are reasons to be optimistic. We believe the opportunity in credit now looks much better, with all-in yields across most parts of the market remaining at elevated levels. While not as cheap as last quarter, investment grade (‘IG’) yields continue to remain elevated relative to history (Figure 3).

Despite being able to make a case for a positive beta tailwind, we continue to believe that it pays to remain selective.

We believe that defaults are likely to pick up in 2023, with an increase in dispersion more generally across markets. There has been an increased dispersion across emerging market (‘EM’) rates and FX and we believe that most areas of credit will follow this pattern this year, as winners and losers bifurcate against a slowing growth environment.

Increased bifurcation will offer increasing opportunities to active investors. However, returns in general may well be dependent on how markets answer three questions.

Firstly, increased volatility in rates has effectively frozen the primary market. There are two possible scenarios that could play out in 2023: higher and lower rates volatility. If we see the latter, it could well thaw out the primary market; but if volatility stays high, how long can corporates avoid issuing into a volatile and higher-yielding environment? In our view, rate uncertainty and general higher yields benefit investors in more complex instruments markets, particularly convertible bonds, which can offer investors the opportunity to outpace price corrections.

Secondly, the direction of earnings momentum remains crucial. If we see corporate earnings continue to decline, we can anticipate negative beta, as falling coverage ratios trigger further selloffs. Against the backdrop of slowing growth and stubbornly high inflation, we believe that it is prudent to remain in non-cyclical sectors and up in capital structure and quality to navigate this period. As such the ability to flex portfolios, rather than simply take on beta risk exposure, will be a major determinant of positive returns in 2023.

Thirdly, we should not underestimate the impact of rising rates on private credit and leveraged loans. Without the regular mark-to-market undergone by public portfolios, there remains the possibility for very sharp price re-sets. Private valuations may well not survive contact with the hard reality of higher interest rates. These floating rate products were the right place to be in 2022, but with the sharp move in rates likely behind us the impact of higher interest costs on companies is likely to bite sharply as growth slows. What was billed as a safe part of the market may indeed see increasing defaults and likely lower recovery given the absence of covenants.

In short, while 2022 has been historically tough at an index level, there are reasons for optimism in 2023 – especially for active investors.

Q1 2023 Outlook

At Man GLG, we have one overriding principle: we have no house view. As such, portfolio managers are free to execute their strategies as they see fit within pre-agreed risk limits. Keeping that in mind, the outlooks below are from the different credit teams at Man GLG.

• Investment Grade: Investment grade yields continue to remain at elevated levels compared to history. It is rare that we find both the interest rate and credit spread component compelling on a valuation basis, but that is the situation that we find ourselves in. We have seen a sharp divergence in regional valuations so far this year and continue to believe this to be an attractive opportunity set to exploit in 2023, especially in Europe and the UK. Additionally, we continue to see a oncein-cycle opportunity in the real estate space which has been hard hit by the rising funding costs. We are also see opportunity in alternative financials such as nonbanking lenders and asset managers, which we feel offer better value compared to more traditional banking counterparts. Finally, it is difficult to speak about investment grade and not have a view on duration. In this case, we actually think it remains a good time to retain exposure to duration in an overall portfolio. With terminal rates at more elevated levels and the potential for slower rate hikes ahead of us the diversification benefits of fixed income could re-assert themselves in 2023 and could make IG a crucial asset class to reconsider.
• High Yield: After a strong rally into the end of the year we believe that high yield (‘HY’) valuations are fairly vaued at an index level, but this clouds significant dispersion beneath the surface. We continue to remain of the view that Pan Europe offers attractive opportunities for investors with some sectors already pricing in recessionary conditions. However, this is not the case for the US. Indeed, we believe that as US growth starts to slow in 2023, this market could widen significantly, pushing aggregate spreads wider, particularly in the early part of the year. Our focus continues to remain in sectors with strong pricing power and in less cyclical parts of the market. This includes consumer staples such as grocery and gaming, health care and TMT. We also maintain a significant amount of exposure in senior portions of the capital structure often in secured investments with strong asset coverage.
  
  We do believe that defaults are likely to pick up in 2023, but with a limited upcoming maturity wall, we believe that they will remain well below prior recessionary peaks. The environment will remain attractive for stressed and distressed investments and we are already seeing a significant amount of opportunity, particularly in Pan Europe focused on the real estate and consumer discretionary space. Additionally, we believe that with many companies conceived during a period of zero interest rates, there will be plenty of opportunities to help good companies with bad balance sheets.
• Leveraged Loans: Loans were the place to be in 2022 as the floating rate nature of the product did well in a rising rate environment. However, this feature cuts both ways and now companies are facing much higher borrowing costs just as earnings start to decline. A large fundamental gap has emerged in favour of the high yield bond market relative to loans, with the latter facing higher exposure to lower-quality rated segments of the market as well as sectors with low recovery rates such as technology. In our view, idiosyncratic opportunities will abound. The Covid-19 pandemic has done significant damage to investment base-cases that originally had very little room for mistakes. The nature of current stresses means that investors should first look for interest coverage and free cash flow metrics, followed by operational agility and stable margins. With the possibility of quantitative tightening on the horizon, strong liquidity for positions remains key.
  
  As one moves down the structures, aggregate leverage in corporate collaterilised loan obligations (‘CLOs’) and Commercial Real Estate (‘CRE’) CLOs is much lower than before the Global Financial Crisis, contributing to robust credit support for senior bonds. Security selection is therefore crucial. We see significant opportunity when gapping occurs in equity NAVs in structured credit, especially during periods of lighter volatility – to us, one of the best indicators of value.
  
  Spread movement is currently relatively muted across global bonds and loans. However, while we may be experiencing a period of calm, it feels like we may have unfinished business there as recessionary drivers develop. Growth and earnings concerns may continue to weigh on HY spreads early next year, even if the Fed pauses its hiking cycle.
  
  In this context loans now look more vulnerable, and a large fundamental gap has opened up in favour of the HY bond market relative to loans. Ratings in LBOs are falling towards B, with higher quality BB almost absent in Europe and issuance low in the US. In our second-quarter fundamental analysis of public loan borrowers, we saw evidence of the slowing earnings and rising interest expense. Low recovery sectors such as consumer staples, cyclicals, parts of technology and retail are beginning to fall under pressure. While it has previously been good to have low energy exposure or financials exposure, tables have turned and these sectors are beginning to outperform.
  
  These factors lead us to prefer opportunities in structured credit markets, especially AAA structured products across a handful of fundamentally challenged agency residential mortgage-backed securities, broadly syndicated loans, CRE loans and AAA middle-market CLOs.
• Emerging-Market Debt: In our view emerging-market debt (‘EMD’) in 2023 will be challenged by the global tightening of financial conditions, the risk of the US and Europe tipping into a recession and China’s structural deceleration. This may well translate into below-trend growth in EM, making it harder for countries to reduce budget deficits and debt ratios. Higher yields in developed markets also means elevated borrowing costs for EM issuers and potential capital outflows, which coupled with still extended positions (particularly in the less liquid segments of the asset class) is likely to keep volatility elevated. Lastly, not only do some 2022 geopolitical tensions remain unresolved, but we will also have elections in Turkey and Argentina to contend with.
  
  Having said that, several EM sovereign high yield hard currency issuers and some select currencies begin to offer value. Additionally, various EM central banks are approaching the end of their tightening cycles, creating space for further differentiation. Lastly, high volatility is likely to create pricing dislocations and originate investment opportunities. Thus, we believe more balanced and active portfolios with combinations of long (overweight)/short (underweight) exposures will be best suited to navigate this environment.
• Convertible Bonds: After the negative performance in 2022, we expect outright convertible bond (‘CB’) performance will rebound in 2023 mainly driven by:

1. ‘Busted’ convertible bonds: Currently, nearly 25% of all global convertible bonds trade below 80 cents on the dollar and more than two-thirds trade below par. This has boosted yields and now 20% of the global CB market trades with a 10% yield-to-worst;
2. Takeovers: While M&A activity has been sluggish in 2022 versus 2021, it’s been sustained in few sectors like tech (mostly software) and health care (mostly biotech), both of which are prominent in the CB space. We expect this activity will continue in 2023, driven by more attractive valuation levels;
3. Refinancing activity: High financing costs will serve as a benefit to the CB primary market (especially versus other asset classes) improving the quality of the investable universe.

In general, even among busted names, the credit conditions of the CB space appear generally healthy. In fact, nearly half of global names have no other debt on their balance sheets other than their convertible bonds. Moreover, even though global CB maturities will approach in the next few years, the majority of ‘busted’ names, do not come due until 2026 and for those names that don’t have negative cash flows, this distant maturity provides ample leeway before issuers are forced to refinance and allowing them to manage the downturn until the economy recovers or borrowing costs become cheaper.

• Convertible Bond Arbitrage: Persistently high rates may make the convertible bond market a more attractive location for companies to issue debt with more palatable coupons than would be acceptable for straight bonds. The zero rate environment of the last decade has meant that corporations could almost issue at will in the leveraged finance market. This has meant that despite the fact that the two markets were of a similar size in 2005, the leveraged finance market has since dwarfed the size of the convertible bond market. Now that we finally have a cost of capital, new convertibles issuance is attractive for arbitrage managers as it creates both opportunities in the primary market, as well as mis-pricings that we can exploit as long only strategies rebalance.
  
  We think investors should re-calibrate behaviours for a new (or return to normalcy!) investment regime of non-zero rates and higher all asset volatility. Disciplined strategies that are active in both the macro hedging side as well as the investment side should benefit from this paradigm. Finally, the next few years may see meaningful growth in the convertible bond market and favourable trading opportunities to come.