Does 2023 have active bond opportunities in store?

Commentary by Kunal Mehta, head of fixed income specialist team, and Suparna Sampath, fixed income specialist, Vanguard, Europe.

• In 2022, most major fixed income credit sectors recorded negative returns during a historically bad year for bonds.
• The outlook for 2023 is much brighter in our view, creating opportunities for active bond investors with a risk-managed approach.
• We believe the best active approach is to focus on bottom-up security selection and relative value within a tightly risk-controlled approach.

Many bond investors will be keen to put 2022 behind them after witnessing a bruising year for the asset class. As global central banks sought to quell a spike in inflation, they rapidly tightened monetary policy, putting bonds squarely in investors’ crosshairs. As a result, most major fixed income credit sectors recorded negative returns during a historically bad year for bonds, as the chart below shows.

A poor 2022 for credit bonds across the board

Sources: Bloomberg indices and J.P. Morgan EMBI Global Diversified Index. Data from 31 December 2021 to 30 December 2022.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

It’s important to acknowledge that after last year’s bond sell-off, there remain further challenges ahead for fixed income. Recession looms, inflation—while off recent peaks in developed economies—remains high, credit spreads are tight and many core developed market economies face fiscal challenges. Heightened volatility could therefore be with us for a while yet.

That said, the outlook for 2023 is much brighter in our view, creating opportunities for active bond investors with a risk-managed approach. Here’s why we’re cautiously upbeat on bonds for the year ahead.

Yields are significantly higher

While most investors probably don’t need reminding that policy interest rates are substantially higher than they were a year ago, they should also bear in mind that bond investors with sufficiently long investment horizons will actually be better off over the next decade than if last year’s sell-off hadn’t occurred.

Investors are now able to access yields that haven’t been seen in years. Yields on bonds are significantly higher than their 20-year average, which means investors have a compelling entry point into the asset class, as the following chart shows.

Yields are higher for most fixed income sectors

Past performance is not a reliable indicator of future results.

Source: Bloomberg. Data period from 31 October 2002 to 31 December 2022. Indices used: UK government bonds: Bloomberg Sterling Gilts Total Return Index Value Unhedged GBP; EUR government bonds: Bloomberg Euro Agg Government Total Return Index Value Unhedged EUR; US government bonds: Bloomberg US Treasury Total Return Unhedged USD; global credit: Bloomberg Global Aggregate Credit Total Return Index Value Hedged USD.

Dislocation is creating new opportunities

In addition to bolstering long-term expected total returns, higher yields mean bond investors have a larger buffer to weather any additional volatility and market shocks. With much of the focus in 2022 on risk-free interest rates, as investors look to a global recession on the horizon, attention is shifting to credit, and whether bond investors will be adequately compensated for recession risk. As it stands, we don’t believe that credit spreads have fully priced in the risk of recession yet.

In this environment, as investors increasingly reach for safety amidst recessionary concerns, demand for high-quality fixed income credit will likely increase, and we expect to see more price dislocation between higher- and lower-quality credit, creating new active opportunities.

Within investment-grade bonds, non-cyclical sectors have historically generated positive earnings growth during recessions, while cyclical sectors have typically experienced declines in earnings. We believe that this will continue to be the case during this credit cycle. We have also observed that credit spreads on BBB-rated bonds are at tight levels relative to those on higher-quality, A-rated credits. Given the elevated risk of recession, we believe this trend warrants monitoring going forward.

High-yield spreads offer little room for error

Among high-yield bonds, credit quality is more resilient today relative to history, having meaningfully improved since the global financial crisis. However, with default rates very low by historical standards, we anticipate that corporate defaults will rise. Further, given the economic backdrop and with current spreads below historical averages, there is little room for high-yield credit spreads to absorb too many more negative surprises, in our view. This potentially lends itself to an active approach grounded in security selection.

Emerging market (EM) bonds will likely benefit from improving growth across EM countries broadly, although behind this backdrop, the picture is mixed. Weaker EM credits are likely to lag a potential rebound given rising external pressures. In terms of spreads, while investment-grade EM credit spreads have tightened recently, high-yield EM spreads remain relatively wide. From an investment flows standpoint, after experiencing outflows last year—and with 2023 likely to be another year of negative net issuance—we believe that EM debt markets will experience stronger technical support in 2023.

Greater opportunity to add value

With economic and geopolitical risks remaining a threat in 2023, we expect more volatility this year. But we also see greater opportunity ahead for active management to add value. Active sector, relative value and security selection decisions should carry more weight in a market that’s not overwhelmed by macroeconomic forces or—as was especially the case following the global financial crisis—dominated by unorthodox central bank policy. Bond investors are more likely to be paid for adding risk in this environment.

To best access these opportunities, we believe the best active approach is to focus on bottom-up security selection and relative value within a tightly risk-controlled approach. This has always been at the heart of our approach to active fixed income, in all market environments.