Is income returning to fixed income?

 

Remember when bonds were bought for income and equities for capital gain?

It feels like it was a long time ago, with the lengthy bull market in bonds delivering decent capital gains and equities becoming the ‘go-to’ asset class for income seekers.

The last 25 years has seen the average annual total return from the non-gilt sterling investment-grade market as over 6%, with investors experiencing only three negative years – 2008, 2018 and 2021. However, given the 2022 return is currently approaching -10, a second consecutive year of negative total returns feels possible.

What has driven this year’s awful performance?

2022 has been a perfect storm for fixed income credit, as central banks around the world have changed their baseline assumptions from transitory to sticky inflation, and sticky to transitory GDP recovery.

Both the resulting policy pivots and subsequent market reactions have been dramatic.

There have been c. 85 rate hikes so far in 2022[2] as global central banks look to deliberately slow economic growth to drive out inflation. Extrapolation is rarely an accurate guide to the future, but at the present pace we could be looking at over 200 rate hikes in 2022!

 

Income: back in the black?

Income has historically made up an important part of total returns, although it has obviously become less powerful as yields have fallen.

While there is no guarantee history repeat itself, this has traditionally been the level of yield at which capital is typically preserved.

 

We believe the outlook for total returns is set to remain uncertain or even challenged – but what about the prospects for the relative return of credit versus gilts?

Here, we see potential prospects for excess returns – ie. those over the risk-free rate – given the spread move we have seen, especially with sterling credit spreads at current levels.

The chart below shows the three-year excess return of investment-grade credit over the last 15 years. Only rarely has this been negative.

 

The table below provides more detail. With sterling investment grade spreads round their current 60^th percentile, our analysis suggests the excess return over the long term could be up to 3.48%:

 

 

Investing is never without risks, however. It is possible that a full-blown recession moves credit spreads across 20 percentiles of historical data – in a recession, spreads could as much as double – although rate cuts and a resulting fall in risk-free yields would insulate investors from this. It’s also possible that inflation could remain sticky and broad-based, in turn driving the US Federal Reserve to  action that could have a negative impact on fixed income and total returns.

It’s also too early in the cycle for any visibility on what could happen after a recession prompted a wave of credit defaults. Investment-grade defaults are generally rare – but rising default risk does affect investment-grade by driving spreads wider.

To summarise: 2022 to date has been the worst ever total return period for credit investors as yields have risen and spreads have widened.

However, the return of income to the asset class could mark the beginning of a new era for investors.

 

 

[1] Source: Bloomberg as at 24 May 2022

[2] Source: Bloomberg as at 24 May 2022