- While such an uncertain environment encourages downside risk mitigation, in our view, idiosyncratic opportunities could emerge if markets punish bonds indiscriminately.
After many years of mostly favorable conditions, fixed income assets now seem to be stuck in a vice of expectations: persistently high inflation, tighter monetary policy, slowing economic growth, mounting debt piles, persistent geopolitical discord. Bond yields have risen steadily in response, punishing long-duration assets like Treasuries, investment grade corporates, emerging market debt and agency papers through the first half of 2022. However, yields generationally lows that preceded the sell-off left even high-yield bonds vulnerable to duration. risk for the first time in their brief history.
Although the pain has been acute in all markets, there are signs that we may only be in the early stages of the turn in the credit cycle. Decades of monetary accommodation and fiscal permissiveness have created the financial market’s equivalent of serene times, suppressing market volatility and preventing the cathartic cleansing of failing business models that accompanies the end of a credit cycle. With the agility of policy-making now hampered by high inflation rates for several decades, it seems that the bill for this period of relative calm is coming to an end.
“In good weather, prepare for a foul,” advised 17th-century English polymath Thomas Fuller, and we’ve long been inclined to agree with that sentiment. Rather than seeking port in the storms that inevitably arise, we continually underwrite our portfolio exposures with the aim of maintaining appropriate levels of risk based on the fundamental backdrop and the spread compensation available in the market.
For Auld Lang Syne
January 2022 started off with a bang, as it looked like investors had decided to shed duration risk in the face of relentless inflationary pressures and financial conditions that had already begun to tighten. Unlike most New Year’s resolutions, however, this one stuck. The 4% loss recorded by long government bonds in January, for example, was just the start of a first-half rout that sent the Bloomberg US Long Treasury Index down 22.3% in a context of
a broad price revision across all asset classes.1 Treasury yields jumped across all maturities, as shown in Chart 1, but fell slightly in the second half of June, with the focus being placed on downside economic growth risks.
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