The macro backdrop of a maturing interest rate hiking cycle by the US Federal Reserve (Fed) plus recessionary risk is creating higher conviction for longer duration fixed income over the next few months.
Rather than looming rate cuts, the higher-for-longer outlook in developed markets globally, combined with a deterioration in many leading economic indicators, suggest a steepening US yield curve, according to AllianzGI.
“We are more convinced of the potential benefits of adding duration risk in the US,” said Franck Dixmier, the firm’s global chief investment officer for fixed income.
“A rally in investment grade corporate bond spreads means we think they are now generally trading closer to fair value, but the carry is attractive and we see some value left in the European market,” he added.
Generally bullish on bonds
In general, AllianzGI sees economic and policy divergence from one country to the next as continuing to offer bond investors a broad opportunity set.
“The versatility and higher yields of this asset class make it a potentially attractive option in this transitional period for markets,” explained Dixmier, pointing to US Treasuries for investors to consider.
At the same time, with ongoing uncertainty around the outlook for inflation, he believes investors could look at markets where rate hiking cycles are more mature by focusing on the positive “real yields”, or returns from interest payments after taking account of inflation. These jurisdictions includes the UK, the US, New Zealand and Mexico.
However, Dixmier warned investors to be wary of euro sovereigns, amid higher recession risks as the European Central Bank tightens further. “Following strong performance from European periphery markets in the first half of the year, we are now looking to build a more defensive positioning on European sovereign debt.”
By contrast, euro corporates look fairly resilient, in AllianzGI’s view. European companies have been able to improve margins and maintain profitability despite higher production costs. “Fundamentals for the sector are healthy, earnings are solid and capitalisation is adequate,” said Dixmier, but warned that construction, real estate and household consumption are showing downside risks.
Meanwhile, in emerging markets, Dixmier said that due to the relatively brighter growth outlook than in developed markets, index yields at an asset class level offer a compelling total return proposition. “A high carry provides a buffer for potential yield increases.”
As a result, the carry of the asset class is still appealing for hard currency sovereigns and corporates, he added. “[This] should continue to attract investor inflows given institutional underinvestment in emerging economies.”
In Asia, local IG names have outperformed US IG, with technicals remaining strong and the sanguine supply outlook potentially supporting spreads. “The carry and yield in BBB-rated bonds, in particular, look attractive,” said Dixmier.
Yet he is cautious about high yield. This partly follows the recent mixed earnings results, where investors saw greater performance dispersion within rating bands and sectors. In addition, lending standards are tightening, funding costs are rising and credit metrics are deteriorating, although HY spreads have continued to rally, especially for lower-rated credits. “We see signs of potential spread widening to come with recession on the horizon in both the US and Europe,” Dixmier added.
He suggested investors should prioritise single-name selection over sector allocation. “Look for companies with lower leverage and higher equity cushions which are less susceptible to higher costs of funding.”
While a similarly measured approach to HY bonds should also apply in the Asia market, AllianzGI is eyeing more attractive valuations in ex-China HY compared with US HY.
