FIXED INCOME OUTLOOK: H2 2023

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Reality will bite for central banks

In the second half of 2023, Ariel Bezalel and Harry Richards (Investment Managers) expect central banks to become more worried about growth than inflation.

As we look forward to the second half of 2023, we expect central banks to finally turn the corner on monetary policy and start to be worried far more about growth than inflation. Central banks, guided as they are by their main KPIs of managing inflation and unemployment, are having their policy action dictated by two of the most lagging indicators it is possible to find. It is the equivalent of driving a car while looking in the rear-view mirror. But if we look forward out the windscreen, there are a range of leading indicators pointing towards recession. Money supply growth in the US is deeply negative, deeper than at any time since the 1930s in fact, and this historically has been strongly associated with recessions. Elsewhere, the excess savings which have supported consumption for the past couple of years have now been virtually exhausted, elevated mortgage rates are leading to housing market stagnation, while the S&P 500 has seen negative earnings for two consecutive quarters and CEOs therefore might think hard about their cost base, with the obvious implications for unemployment. So is the US headed for recession? Whether or not it enters a technical recession is anyone’s guess, but we certainly feel strongly that the idea of the US economy experiencing a soft landing is wishful thinking at this point. Policy has tightened so much, and so quickly, that it has not yet fully fed through into the real economy. Even if the Fed halted rate rises today (and their rhetoric suggests they might still have one rise left in them before reality bites) then the economy would still keep feeling the impact of that tightening for months to come. An environment in which inflation keeps rolling over, growth falters, and the employment picture worsens is one in which continued hawkish policy from the Federal Reserve will rapidly become untenable and cuts will follow. In our view this lays the foundation for an extremely promising investment environment for fixed income. The investment opportunity, as we see it, is an enticing one. As we come off the back of one of the worst bond market sell-offs in history, valuations especially in government bonds have gone from expensive to very cheap in our opinion. Away from the world of government bonds, our economic outlook means we have been getting more cautious on credit in aggregate. Credit markets, led by the high yield market, have continued to perform pretty well, but they are not yet pricing in the slowdown that we foresee. But that doesn’t mean credit is without opportunities! However, our preference is for the more defensive sectors, secured structures and bonds with shorter maturities or nearer term call dates. We have a high level of conviction in our macro view, but of course we know that nothing is guaranteed and there are factors which could de-rail the world from this path, including China generating a rapid economic turnaround, governments stepping in to shield the public from the impact of higher rates (e.g., mortgage rate relief), and a new spike in food price inflation perhaps driven by adverse weather or Russia/Ukraine abandoning existing grain agreements. The world is an unpredictable and volatile place, as we’ve all had ample evidence of in recent years. But the vast breadth of fixed income asset classes available means we have confidence that, whatever fate throws at bond markets, a flexible and dynamic global bond portfolio should have the tools at its disposal to meet that challenge.

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Ariel Bezalel and Harry Richards Investment managers

Multi-sector / macro

Fixed Income Outlook: H2 2023

In the last twelve months the market consensus has lurched from inflation (summer ‘22), to stagflation (Q1 ‘23) to “immaculate disinflation” (summer ’23). The consensus rarely turns out to be right, and the future will be volatile. Rate hiking cycles often end in surprising and unpredictable ways – that’s when active management comes into its own.

At Jupiter we’re fortunate to have a large and highly experienced team of fixed income investment professionals, running a suite of strategies that spans the breadth of the asset class. It is central to Jupiter’s investment identity that we have no ‘house view’. Our skilled investment managers are free to form their own opinions on the market. What unites them all is a deep commitment to active management, whether in choosing companies to entrust with our investors’ capital or helping our clients through the ups and downs of a market cycle. Please note that these articles were published in August 2023. Click the button below to see them showcasing their diversity of opinion, and we hope you find their views interesting and stimulating.

Matthew Morgan

Head of Fixed Income

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estate to telecommunications and we invest in a variety of instruments across a wide ratings spectrum in developed and emerging markets. Our experts share their views on the evolving picture in the global credit markets. We hope you find their insights useful and valuable.

While yields look attractive at current levels, credit selection is of the utmost importance. Avoiding underperforming sectors and debt-laden companies that could be potentially downgraded is even more important than choosing the winners. At Jupiter, our team of experienced credit analysts carry out rigorous fundamental research to make appropriate decisions whatever the macroeconomic environment. We scan for opportunities across a range of sectors from real

Yields on bonds issued by corporates have shot up as central banks have tightened their policy to tame runaway inflation. What does the future for this segment of the fixed income market look like as the economy weakens in many countries?

Credit Markets Outlook: H2 2023

What have Jupiter’s credit analysts been up to?

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Vikram Aggarwal Investment manager

Sovereigns

Harry Richards and Adam Darling Investment managers

Investment Grade

Leon Wei and Andrew Rubins Credit Analysts

The Credit Analysts' View

Alejandro Aervalo,
Alejandro Di Bernardo
and Reza Karim

Alejandro Arevalo, Alejandro Di Bernardo and Reza Karim Investment managers

Emerging Markets Debt

Mark Nash, James Novotny and Huw Davies Investment managers

Fixed Income absolute return

Lee Manzi and Makeem Asif Investment managers

Convertibles

Hilary Blandy Investment manager

Multi-sector credit / regular income

Adam Darling Investment manager

High Yield

Luca Evangelisti Investment manager

Financials credit

Their insights below provide a deeper dive into the fixed income universe.

At Jupiter, we’re fortunate to have a broad and deep pool of talent on our fixed income desk – investment managers and credit analysts who are subject matter specialists.

Harry Richards and Adam Darling Investment managers

Investment Grade

Adam Darling Investment manager

High Yield

Alejandro Arevalo, Alejandro Di Bernardo and Reza Karim Investment manager

Emerging Markets Debt

Vikram Aggarwal Investment manager

Sovereigns

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Ariel Bezalel Investment Manager, Fixed Income

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Harry Richards Investment Manager, Fixed Income

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Vikram Aggarwal Investment Manager, Fixed Income

We went more than a decade in which yields in sovereign bonds were lower and lower. In developed markets (DM) such as Germany and Japan, government bond yields were negative and simply not investable. That has changed in the last 18 months, and sovereigns are once again an income generating asset class. It’s possible to have a portfolio of high-quality government bonds with yields in the mid- to high single digits. We see a strong rationale for investors to allocate to sovereigns and, in particular, to an actively managed, unconstrained global sovereign bond strategy. Sovereign bonds are the largest part of the fixed income universe and the most liquid, so there are, in our view, significant opportunities in this universe of 166 countries, including DM, emerging markets (EM) and frontier markets. Soft landing? Our approach is to start by formulating a global macro-economic outlook, whilst identifying key economic or market trends. We then identify countries with improving or deteriorating outlooks and begin to construct a portfolio that’s optimised to deliver attractive risk-adjusted returns. Our macro view is that market participants will shift their focus from concerns over high inflation to concerns over low growth. With the US Federal Reserve pausing its rate-hiking cycle in June, at the same time as “hard’’ economic data was outperforming expectations in DM economies, market participants have placed a higher probability on a “soft’’ economic landing in the US. We believe this optimism is misplaced and see a “hard’’ landing scenario as most likely. We also believe that historically tight monetary conditions have increased the propensity for additional financial accidents such as those we saw at Credit Suisse and Silicon Valley Bank. China risks It’s also important to note the risks related to the weakness in the Chinese economy, which has seen stagnating industrial production and very low or negative inflation. We expect the policy response from Chinese authorities to be focused on stabilising rather than stimulating the economy, and prioritising consumption over investment. We believe this has profound implications for the rest of the world, especially exporting EM economies and the Eurozone, which have relied on demand from investment spending in China to drive their domestic economic growth for several decades. We think credit spreads are overly tight, reflecting excessive market optimism, and we think it makes sense to reduce credit spread exposure. Owning a mixture of high-quality DM and EM local-currency sovereign bonds is sensible, we believe. In the interest rates space, in DM, our preference would be for duration exposure via US, UK and Swedish government bonds. These are economies where we would expect to see slowdowns and signs of disinflation, and central banks may not be able to raise rates as much as the market expects. The UK and Sweden also have extremely weak housing markets. Likewise, in EM, South Korea is facing a slowdown in credit growth and activity and has an over-leveraged economy. Rates and FX We are more positive on the rates outlook in Latin America, including Brazil, where the central banks moved quickly to address inflation. Looking at sovereign spreads, it is mostly about selectivity. After a lot of pessimism had been priced in 2022, in the more recent months of 2023 we have seen a recovery in many of the idiosyncratic investment cases such as Ukraine, Egypt, Nigeria, El Salvador, Mozambique and Pakistan. In FX, 2023 so far has been about carry and real yields. Several EM currencies such as the Brazilian real and Colombian peso, offer today meaningfully positive real yields to investors. In the developed markets, the Japanese yen could offer investors upside if a normalization of monetary policy were to start in Japan. Concerns over prospects for economic growth and still relatively modest real yields instead make us more bearish on the outlook for the euro and British pound. While we are somewhat cautious about the outlook for global economic growth, we think this environment is ideal for investors and active fund managers in the wide and deep market of global sovereign bonds.

Vikram Aggarwal discusses the remarkable rebound in sovereign bond yields, opportunities and risks in the asset class and macro outlook.

Global Sovereigns: Best entry point in a decade?

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FIXED INCOME OUTLOOK: H2 2023

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Europe While Europe might be a relatively small component of our universe, the region has been lately enjoying positive surprises. Ukraine has been the most positive story so far this year. International support and solid possibilities of an internationally financed reconstruction plan are part of the story. As corporates and segments of the economy continue to function even in an extremely complex setup, investors have been willing to buy the country’s debt. Further east, countries such as Azerbaijan, Kazakhstan or Uzbekistan offer interesting opportunities especially in the energy sector, but interesting idiosyncratic opportunities can be found also in more peripheral countries such as Georgia or Moldova. We remain overweight the region.

Alejandro Arevalo, Alejandro Di Bernardo, Reza Karim and Xuchen Zhang say emerging markets debt could offer a positive environment over the next six to twelve months, with alpha generation hinging on credit selection.

Time for generating alpha

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Alejandro Arevalo Investment Manager, Fixed Income – EMD

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FIXED INCOME OUTLOOK: H2 2023

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Alejandro Di Bernardo Investment Manager, Fixed Income – EMD

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Reza Karim Investment Manager, Fixed Income – EMD

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Xuchen Zhang Investment Analyst, Fixed Income – EMD

After a very challenging 2022, the first half of 2023 has been more generous for emerging market debt investors. Last year’s adjustment has been painful, but the asset class provided much higher carry as a starting point for 2023 and investors shrugged off some volatility to realize such carry. Selectivity will be key in order to continue to capture such positive carry in both sovereign and corporate debt. In this sense, we do think the next six to 12 months could be a positive environment for credit pickers, but the journey might not be smooth. US: lower growth and inflation means fall in Treasury yields Indeed, 2022 was the year of inflation, which meant that fixed income investors had to make painful adjustments. As central banks frantically tried to quell inflation that proved to be much more entrenched than earlier thought, government bond investors grappled with an abrupt change in reality. While focused on EM, as dollar-denominated debt investors, we always keep an eye on the potential trajectory of US macroeconomic developments. We are cautiously optimistic on the inflation picture in the US, but this will probably come at the cost of a slowdown in the US economy. We believe from now on the US Federal Reserve (Fed) should probably enter a fully data-dependent stance. As natural lags in monetary policy play through, we see low chances of a much higher level of terminal rate. This means US Treasury yields should start declining from here, or at least remain more stable than what we witnessed in the past 12/18 months. Key consequence for us is to keep generally an overweight stance to interest rate exposure. China: more stimulus ahead, but will it be enough? It is fair to say that China’s recovery after Covid hasn’t matched investors’ expectations. What we’ve seen so far is a mostly services-driven recovery, with manufacturing lagging behind. Latest Purchasing Managers’ Indices (PMI) data show manufacturing contracting. CPI is on the verge of deflation, while Producer Price Index (PPI) is already in proper deflationary territory. This might be a positive news for those looking for global disinflation but paints a grim picture for demand in China. Naturally, the reaction has been one of additional support both in terms of monetary policy and continuation of targeted relief measures for the property sector. A somewhat less hawkish stance vs large private corporations in the technology space has emerged as well. In a nutshell, we have seen a pivot from idealism to pragmatism. We think there will be more stimulus and more support for the property sector and the broader economy in the pipeline. This positions us in the middle camp when it comes to our degree of conviction on Chinese growth. We believe the 5% growth target is reachable, but we do not expect huge upside surprises. When it comes to property, we think that the issues of demand are more structural than cyclical. It is hard to conceive what kind of public support might completely solve the imbalances. EM ex-China: welcome disinflation One of the most surprising outcomes of the Covid cycle was an unusual occurrence in which inflation in the developed markets surpassed inflation in EMs (on aggregate). One key factor that has helped EMs to avoid a sharp acceleration in inflation is the credibility shown by central banks. Rate hiking cycles in EMs started well before what was seen in developed markets. While developed economies grappled with a rise in services sector inflation, it is a smaller component of consumer price baskets in EMs. The asset class also benefited more from commodity price disinflation. The net result is that today EM central banks sit on a meaningful cushion of positive real rates. This might help to ease monetary policy and support economies down the line, but we do not expect a massive round of rate cuts from here. We think EM central banks are going to mostly follow the Fed, as the price for early easing might be excessive currency depreciation.

EM sovereign EM sovereign debt (in hard and local currency) has been enjoying a positive ride since the beginning of the year. Many positive (and often unexpected) idiosyncratic stories started to play out, spurring a strong recovery in the valuation of some more complicated names. Ukraine, Turkey, Nigeria, Egypt, Pakistan, Ghana and Zambia have seen positive developments. We think the “high yielding” countries still offer interesting opportunities at the moment. When it comes to “high-grade” or in any case larger countries, instead, we think that the local market can offer some interesting opportunities given the high real yield cushion (on expected inflation) enjoyed by many countries such as Brazil, Indonesia or Hungary.

EM Corporates: positive fundamentals The fundamentals of EM corporates remain positive. Compared to historical data and developed markets, net leverage is relatively low, which is a significant advantage for the asset class. Looking ahead, we anticipate the potential for increased dispersion. One key factor that has benefited many corporates in 2023 has been the manageable wall of refinancing. However, in the coming years, this maturity wall is expected to become more challenging. We perceive a certain level of refinancing risk due to the rising cost of debt that many issuers will have to confront following the recent sharp tightening cycle. In addition to bonds, the rollover of loans poses an additional refinancing risk, particularly for certain unique situations that could potentially impact the market on a broader scale. While we still identify interesting opportunities within the asset class, our approach to evaluating corporates has evolved. Previously, we sought growth stories that could outpace their debt, but now we prioritize resilient stories that can navigate the refinancing cycle without difficulty or those that have already taken proactive measures. On the other hand, the reason for the refinancing risk can be attributed to relatively weak net new issuance, which has remained negative throughout 2023. This low net issuance continues to be a positive technical factor. From a valuation standpoint, although there has been some volatility, we are currently not far from where we began the year. Most of the positive performance has been driven by the natural carry of positions, underscoring the validity of the yield story that was highlighted at the start of the year. We believe the current environment offers the potential for attractive returns, provided that caution is exercised in avoiding weaker names on the refinancing list. This is a time where alpha and credit selection can be particularly advantageous.

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Africa

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REGIONAL VIEW

Africa The big positive of late has been Nigeria, thanks to an unexpected agenda of reforms from the new government. We recently reengaged in the country and find additional safety when investing in USD-earners. We are less enthusiastic about South Africa, mostly because relative valuations are less interesting. The rest is effectively mostly about single name stories that we consider detached from the broad macro picture in the region, which remains highly diverse. Countries where we are currently active are for example Mauritius, Morocco and Tanzania. We remain overweight the region.

Middle East Oil prices have benefited countries such as Saudi Arabia, UAE or Oman, with a massive improvement in fiscal balances. Kuwait alone has seen its budget deficit improve by roughly 19% during the year. Fundamentals already reflect all of this, and valuations have been pretty resilient around the wide levels seen in 2022 , making valuations more expensive across some issuers on a relative value basis. 2023 has seen some underperformance in the corporate space that has prompted us to once again increase exposure. When investing in large countries (e.g. UAE, Saudi Arabia), we prefer to express our allocation via more interesting sectors such as real estate, financials or logistics. Otherwise, we find some interesting opportunities in the HY space (e.g. Oman). We remain overweight the region.

LATAM After being positive on the region for a relatively long time we recently switched our stance to more neutral. Our view of a somewhat slowing cycle demands a lower cyclical exposure, and the region is home of various cyclical corporates in basic materials or industrial sectors. Monetary policy remains a positive aspect in LATAM. Central banks have been fighting to keep their reputation intact. In recent quarters policy, their policy has shown however some volatility as seen in the likes of Peru, Brazil, Colombia and Ecuador. Our favourite country at the moment remains Mexico thanks to nearshoring opportunities and a combination of stable politics, positive growth and high real rates. The country offers interesting opportunities in defensive sectors such as utilities or telecommunications as well as some good value across financials. Other countries where we find interesting are Paraguay, Panama and the Dominican Republic. Brazil offers a good opportunity in local currency bonds. We expect growth to decelerate in the second half of the year, although from a strong base and one of the highest in the region. We remain cautious in Chile, where growth continues to disappoint, and we now expect flat growth for the year. We are currently neutral the region.

Asia Asia has been a structural underweight for a long time for us. For both sovereigns and corporates, there are a lot of investment grade issuers with tight spreads offering limited space for value generation through credit selection. Debt issued by the region’s corporates is a very meaningful component of indexes (over 40%), which we as credit selectors find it unnecessary to match in terms of our regional allocation. More recently, as we became more defensive, we started to reengage with some of the investment grade names in the region. Thanks to higher underlying rates, we can lock up attractive carry from very high-quality issuers. Leaving aside large investment grade capital structures, the HY component in Asia remains highly volatile and especially in China. Markets are prone to sizeable sudden shifts as unexpected defaults or weak earnings alternate with new speculations on possible government intervention. Therefore, we avoid large fundamentals based active positions in the country as daily technicals remain highly unpredictable. Indonesia and India look positive to us, thanks to a positive macro backdrop (solid growth, supportive policy and robust onshore liquidity) and a diverse set of corporate opportunities as well as interesting value in local currency. We remain underweight the region.

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After the widespread disruption caused by last year’s sharp increase in interest rates, the markets expected some respite this year. They assumed a straightforward script: high interest rates to suppress elevated inflation would cause a severe recession prompting central banks to relent on their hiking path. However, the story line hasn’t followed a familiar fairytale route and has seen many twists and turns. Growth has remained resilient, and inflation has proved to be sticky, surprising central banks as well as the markets. The turmoil in the US regional banks raised financial stability concerns and briefly raised hopes of a halt in rate hikes earlier this year. However, banking woes seem to have subsided for now and major central banks, including the Federal Reserve have vowed to raise rates further to win the inflation battle. The year saw central banks and markets becoming heavily dependent on every new piece of information for making the next move. The plot moved between “hard landing,” “soft landing,” and “no landing”. In this scenario, markets have behaved in an erratic manner, with both bonds and currencies moving in a wide range. The lack of directionality in the markets made portfolio management a highly complex exercise, with multiple investment themes emerging on a weekly and sometimes daily basis. The first half ended with yields still rising, curves flattening and the US dollar gaining against cyclical currencies. This is the type of price action one sees at the end of the cycle. Talk of a deep recession is now in the air. Debt levels have fallen But this could be a red herring and we do not anticipate such a scenario as the current situation is way different from the high debt levels seen after the Global Financial Crisis. Consumers as well as corporates are now deleveraged. On the fiscal side, it seems as if governments have forgotten the word ‘austerity.’ For instance, a textbook reaction to tackle inflation in the UK would have been to increase taxes. That would have an across-the-board effect on demand and back the Bank of England’s fight in taming inflation. However, policy makers are coy about even uttering ‘austerity’, particularly ahead of next year’s election. Public sector wage increases announced by Prime Minister Rishi Sunak could add to inflationary pressure. The labour market continues to be tight, with low unemployment levels and a rise in wages, which is further fuelling demand and inflation. There is an argument that the ageing demographics could be deflationary but a counter point to that could be that a shrinking workforce could be inflationary as well. Geopolitical headwinds Stronger structural demand from geopolitical changes will also spur more broadbased spending. Nations are increasingly building capacities within their borders following the supply chain debacle caused due to reliance on China during the pandemic. Higher investments related to the green transition as well as a boost to defence expenditure amid the Russia-Ukraine conflict may also underpin demand. Inflation has declined at a glacially slow pace over the year, with the manufacturing sector suffering as demand shifted to services after covid lockdowns ended. This has left manufacturers holding expensive inventory, which they’ll try to offload over the next three to four months in an attempt to bring back demand from services. We expect the Fed to pause in the coming months, which could be followed by some rate cuts. Such a scenario will reduce volatility, steepen the curve, and improve the environment for investments in bonds. However, we don’t expect any aggressive cuts as the foundation of growth continues to be solid. Flexibility is key We also believe developed market central banks won’t revert to the low interest rate regime witnessed over the past decade as inflation may continue to hover above targets for much longer. In contrast, we see value in emerging markets, in both hard and local currency bonds. Emerging markets are now ready to reap the benefits of hiking rates at the right time in 2021, when their counterparts in the developed world were taking it easy. We particularly like bonds in Brazil, Mexico and South Africa. Managing fixed income assets in an unpredictable macro environment calls for a lot of flexibility. While the flavour of a season could drive investors towards one fixed income strategy or the other, absolute return strategies are designed to work in all environments. Our approach is to focus on predicting the macro call correctly, which forms the basis for the direction in which interest rates are headed. We believe, if we get that call right, the plot will sort itself out, and help us generate alpha.

Mark Nash, James Novotny and Huw Davies say policy makers could keep interest rates higher for longer as strong growth foundations underpin inflation.

A fairytale ending?

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Mark Nash Investment Manager, Fixed Income – Absolute Return

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FIXED INCOME OUTLOOK: H2 2023

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Huw Davies Investment Manager, Fixed Income – Absolute Return

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James Novotny Investment Manager, Fixed Income – Absolute Return

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Harry Richards and Adam Darling Investment managers

Investment Grade

Vikram Aggarwal Investment manager

Sovereigns

Alejandro Arevalo, Alejandro Di Bernardo and Reza Karim Investment manager

Emerging Markets Debt

Their insights below provide a deeper dive into the fixed income universe.

At Jupiter, we’re fortunate to have a broad and deep pool of talent on our fixed income desk – investment managers and credit analysts who are subject matter specialists.

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One of the key benefits of owning convertible bonds that we believe to be particularly relevant in the current market is they offer the potential for improved risk-adjusted returns within a portfolio of stocks and bonds. A convertible is a corporate debt security that usually pays interest like a conventional bond with the promise of par at maturity but has the additional feature that it can be converted into a set number of the issuer’s common stock at a set “strike’’ price, usually at the discretion of the bondholder. The option to convert the bond to shares provides upside potential should equity markets rally and the stock price increase. whilst downside support comes from the bond’s coupon payments and principal at maturity. If we look at the macroeconomic environment, whilst it’s clear that inflation has been much stickier than central bankers and investors had previously thought, the trajectory is lower. The consensus is that interest rates have either peaked or are near peaking across various markets, but the key question is what impact these higher rates will have on the economic environment. We do expect a slowdown to materialise over the coming quarters but believe that anything more than a mild pause in growth will result in the US Federal Reserve and other central banks loosening policy and therefore limiting equity weakness. We saw cracks in US regional banks and in the property space earlier in the year, but these have so far had limited impact on markets This heightened uncertainty is likely to result in higher volatility from what we believe are currently artificially subdued levels, which should benefit convertibles. Turning to the credit cycle, we think it makes sense to own a portfolio of convertible bonds with an “implied’’ credit rating that is investment grade and that has a low duration in order to have downside support from volatile markets and credit uncertainties. New opportunities are arising for investors as issuance trends have returned to healthy levels after a very weak 2022. Last year, about $40 billion in new issues came to the convertibles market, which in total is about $450 billion and has an average maturity of five years. That means around $85 billion a year in new issues are needed to sustain the market at current levels, which also happens to be the long-term issuance average. In 2020 and 2021 there were about $160 billion each year. This year through June has seen about $40 billion, so we are around the average run rate. The convertibles universe also has improved with a broader base of issuers offering higher yields and equity optionality. US utilities are among the recent new issuers, whilst unprofitable technology has taken a back seat from the elevated levels, seen in 2019 and 2020 We also see opportunities in Asia, where we believe the risk profile and valuations to be favourable, and the US is looking more attractive with positive issuance patterns.

Lee Manzi and Makeem Asif discuss the trends in convertible bonds regarding valuations, volatility and issuance.

Making the case for convertibles

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Makeem Asif Investment Manager, Fixed Income - Convertibles

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Lee Manzi Investment Manager, Fixed Income - Convertibles

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FIXED INCOME OUTLOOK: H2 2023

Ariel Bezalel and Harry Richards Investment managers

Multi-sector / macro

Mark Nash, James Novotny and Huw Davies Investment manager

Fixed Income absolute return

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Investment grade bonds are now trading near the cheapest levels since the Global Financial Crisis, which provides a rare opportunity for investors to lock-in high yields in a relatively safe part of the credit market as potential recession looms. Major central banks including the US Federal Reserve (Fed), the European Central Bank and the Bank of England (BOE) have boosted their policy rates aggressively over the past year to induce a slowdown in growth and tame inflation. That effort is already bearing fruit. US consumer prices index rose 3% in June, above the Fed’s 2% target, but much below the 9.1% recorded in the same month of 2022. In the UK inflation recently surprised to the downside as well and is now poised to quickly decelerate in the coming months. Inflation in other regions is also slowing. We believe central banks have broken the back of inflation. That’s good news for investment grade bond investors, who can now look forward to much higher real returns, with market yields having trebled over the past two years. As growth falters, defaults at the lower rung of the credit spectrum may increase, further bolstering the appeal of high-grade bonds. Long duration 2022 and early 2023 saw one of the most extreme increases in government bond yields in modern history as the fear of sticky high inflation led central banks globally to embark on aggressive rate hiking cycles. Investment Grade bonds suffered in this environment because of their relatively long duration, and hence higher exposure to interest rate volatility. The pain was even more pronounced in the Sterling high grade bond market, especially in recent months, as persistently high inflation in the UK caused the BOE to take an even more hawkish stance than other central banks. Improving prospects All that may be set to change for the better now as central banks are near the end of their monetary tightening spree, and leading indicators of the economy suggest that inflation globally will continue to fall towards the 2% target. In this environment we think that longer duration assets, such as investment grade corporate bonds, could fare better both in terms of absolute and relative returns in comparison to other asset classes.

Adam Darling and Harry Richards say investors have a once in a generation opportunity to lock in high yields in the investment grade corporate bond market.

Strong tailwinds

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Adam Darling Investment Manager, Fixed Income

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Harry Richards Investment Manager, Fixed Income

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FIXED INCOME OUTLOOK: H2 2023

Sterling IG corporates currently offer materially higher yield vs equities

In recent months risk assets and especially equities have rallied hard on the basis that perhaps a “soft landing” might be achieved after all. We believe such an assumption might be misplaced as leading economic indicators in the Eurozone, the UK and China signal the potential for a widespread recession in developed markets. Additionally, history tells us that monetary policy tends to act with “long and variable lags”. The lagged effect of past interest rate hikes is only now starting to percolate through many economies. We have also witnessed a significant tightening in bank lending standards and demand for credit which historically have been precursors to economic slowdowns. If we were to face a material recession across developed markets, inflation will likely fall even further, and interest rates could be cut aggressively. This would be a positive scenario for high quality long duration assets as yields on government bonds would see a meaningful decline from current levels. Investment grade bonds, with low default risk and robust issuer characteristics, would be expected to materially outperform riskier asset classes into a weakening economic environment. Even if the path towards lower interest rates is not linear, current yield to maturity for investment grade bonds provides a much better starting point for investors when compared to 12/18 months ago, providing a more asymmetric payoff profile in different scenarios for rates. UK credit The UK investment grade market looks particularly interesting at the moment. Credit spreads are relatively cheap compared to long-run average/median spreads and look cheap relative to other investment grade markets globally (such as the US and Europe). This contrasts with tight spreads, for example, in the high yield market. The UK government is heavily indebted, and the consumer is also experiencing stress from higher interest rates which we expect to act as a headwind to growth in the coming months. What’s not good for the economy is invariably good for bonds as falling growth and inflation support the return potential of long duration assets. However, careful credit selection will be key as companies and their bonds will perform differently in a weaker, more fearful market. Recent volatility has created interesting tactical opportunities in sectors such real estate and financials. Real estate, in particular, is one of the sectors that suffered the most from the increase in interest rates. While fundamentals and certainly current news flow do not look bright for the sector as whole, in certain situations markets appears to have overreacted. Companies with high quality portfolios that are largely unencumbered, modest leverage and low prevalence of floating rate debt can offer attractive value. In contrast, we are quite cautious on sectors with a higher degree of cyclicality such as consumer discretionary or industrials. Across ratings, we see limited value in the A-rated segment of the market, while BBBs seem to offer more compelling risk/return prospects after their recent underperformance. Retaining some very high quality AAA and AA rated bonds in a portfolio helps to hedge against future volatility. Credit selection To be sure, as active managers we place a lot of emphasis on credit selection in the investment grade market and try to avoid underperforming sectors and bonds of debt-laden firms that could be potentially downgraded. The crisis faced by Thames Water, Britain’s biggest water supplier, is a stark reminder of the importance of fundamental research. Even if there are no defaults, one needs to watch for credit spread volatility. Overall, as we gear up for a recessionary world, we believe investors will flock to the relative safety of the investment grade market, with the attractive yield on offer a bonus. The market now offers an attractive entry point for locking in high yields, with the added advantage of boosting real returns as inflation softens. The shock of the drawdown in the bond market through 2022 means investors are a little cautious about their exposure to the asset class but that’s typically a good indicator of a favourable entry point.

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Harry Richards and Adam Darling Investment managers

Investment Grade

Vikram Aggarwal Investment manager

Sovereigns

Alejandro Arevalo, Alejandro Di Bernardo and Reza Karim Investment manager

Emerging Markets Debt

Mark Nash, James Novotny and Huw Davies Investment manager

Fixed Income absolute return

Ariel Bezalel and Harry Richards Investment managers

Multi-sector / macro

Their insights below provide a deeper dive into the fixed income universe.

At Jupiter, we’re fortunate to have a broad and deep pool of talent on our fixed income desk – investment managers and credit analysts who are subject matter specialists.

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We have recently had a stealth bull market in high yield. Credit spreads tightened and high yield performed well in the first half of 2023. Investors have been increasingly relaxed about recession risk – many have bought into the “soft landing’’ narrative – believing that central banks can perfectly land the plane. Our view is that the market may be too complacent about the lag effects of monetary policy: interest rate hikes are a powerful tool, but they percolate through the global economy slowly, causing more and more damage as governments, businesses and consumers progressively have to refinance their debt. The huge amount of monetary tightening by the central banks over the last 12 months is only now hitting consumers and businesses and we’re likely to have a recession, potentially very soon. Default rates will increase, and there will be greater volatility in the high yield market, which may mean more dispersion in performance among issuers and sectors. These are scenarios that disciplined active managers can take advantage of. The yields on offer in high yield are indeed high relative to history, and they offer the potential for attractive future returns; but in this environment, selectivity will be even more important to avoid the weaker names. Muted issuance We have been surprised at how well the high yield market has held up in an environment where banks have dialled back on risk appetite, making it harder for companies and consumers to access credit. Historically, these conditions would lead to credit spreads selling off, whereas this time high yield markets continued to be highly resilient. Part of the reason for this may be market technicals, as muted new issuance has driven investors to chase existing bonds. We do not think however that such broad-based strength can be sustained in the medium term, and investors might need to avoid situations that do not price in a weaker macroeconomic environment. We think it makes sense for high yield investors to be more cautious today in portfolio construction, such as owning more lower-risk bonds and keeping higher cash balances to provide a risk hedge as well as dry powder that can be used to take advantage of selloffs and dispersion in the market. Avoiding cyclicals Nevertheless, the current market also offers opportunities to own bonds that price in the relatively weak economic environment. From a sector standpoint, given our recessionary macro view, we think it makes sense to stay away from the more cyclical parts of the market – consumer discretionary companies, industrials or companies that are too highly levered. Healthcare and consumer staples, traditionally defensive sectors, look more attractive. In recent quarters we found also idiosyncratic opportunities in the energy sector and more recently in the financials space. Looking through a credit rating lens, BBs look to us to be the least attractive. Bs and potentially even some tactical opportunities in the BBBs, look more interesting considering current valuations. In developed markets, UK monetary and fiscal credibility is strained, interest rates are high, and people are worried about inflation. Ironically, this negative sentiment provides good opportunities to selectively buy high quality UK businesses at a big spread premium vs similar businesses in other regions such as the US. Judicious selection Emerging markets are interesting because some high yield bonds there are pricing in a pretty bleak economic environment. In Latin America, for example, some hard currency bonds, issued by relatively solid business, are offered today at valuations already consistent with a recessionary environment, providing a good risk/return opportunity. Given the outlook for a more volatile market, we believe that judicious credit selection and risk awareness will be crucial to delivering solid returns in high yield for the near future. That means being active, intensively researching credit selection to drive risk-adjusted returns; being pragmatic, neither overly aggressive nor defensive; and being risk aware, to preserve capital and avoid idiosyncratic drawdowns. The context is not however entirely negative for investors. Despite our caution on the global economy, history suggests that over the medium term, high yield is positioned to deliver attractive returns. To fixed income investors, yield is everything and the radical re-pricing of interest rates since 2021 has left yields very high relative to long-term average. We believe this provides a margin of safety to compensate for volatility and potentially higher default rates. If it turns out that we are overly pessimistic and we end up having that soft landing as inflation falls and central banks dial down their hawkishness, we believe high yield will be very attractive under those conditions, too.

Adam Darling discusses yield trends in high yield bonds and why credit selection is so important.

Staying active and selective in global high yield bonds

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Adam Darling Investment Manager, Fixed Income

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FIXED INCOME OUTLOOK: H2 2023

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The Contingent Capital (CoCos) asset class has experienced a tumultuous start to 2023, rocked by the collapse of Silicon Valley Bank, Signature Bank, First Republic and Credit Suisse. The March events initially generated a dramatic re-pricing across the capital structure of global banks, with spread showing material widening in the senior, Tier 2 and AT1 space. AT1 securities, in particular, suffered from significant volatility in the days after the Credit Suisse event. Clarifications from various regulators around the globe however provided an important pillar to assuage lingering doubts surrounding the asset class. The landscape has improved recently, bolstered by strong quarterly performance of EU and UK banks, a more resilient macro backdrop and a gradual slowdown of inflationary pressures. These have all supported a gradual recovery for bank capital. As a result, CoCos spreads have already started to tighten from the extremely wide levels seen in March, and the asset class remains one of the most attractively valued areas of the fixed income market. The road ahead So, where does this leave the asset class as we head into the second half of the year? Whilst a moderate and gradual deterioration in banks’ asset quality in H2 2023 and 2024 is likely, our view is that banks have significantly improved their fundamental position over the last 15 years, including a strengthening in lending standards, liquidity levels and capital position. In our view this will allow them to absorb the future increase in cost-of-risk associated with a potential economic slowdown in Europe and UK. In fact, despite the idiosyncratic situation at Credit Suisse, the banking sector in Europe is probably as good as it has ever been when it comes to balance sheet quality. Banks have been deleveraging ever since the Global Financial Crisis, selling underperforming assets as demonstrated by average non-performing loan exposures decreasing from 4.5% five years ago to below 2%. We also expect the UK banking sector to continue to be resilient despite market’s concerns around mortgage refinancing risk and the potential slowdown of economic activity. Liquidity and stickiness of deposits remain highly relevant topics after the turmoil seen in the US regional banking sector. Even on those metrics, however, European banks continue to exhibit good resiliency, with high percentages of insured deposits and clients less inclined to shift their savings to the money market space. A shift from current deposits to term deposits has also been a noticeable trend. In this environment we think that Contingent Convertibles bonds (CoCos or AT1s) are currently trading cheaply on a historical perspective with a yield to worst above 9% (unhedged) and spread in excess of 500bps. Current relative valuations are also very attractive especially compared to the European and US “high yield” markets and also to US banks preference shares. What this means for the Contingent Capital strategy In terms of our CoCos strategy, we think it makes sense to look at gradually increase duration as we expect that central banks will have to shift to a more dovish rates policy in 2024 as the economy weakens and inflation pressure eases. We also think that credit selection is of paramount importance, and it is a good time to own higher quality CoCo issuers — to sacrifice a little yield if necessary to stay with the strongest institutions. We think that this will allow CoCo investors to lock-in very good yields without taking excessive risks in an uncertain macro environment and volatile markets. From an issuer standpoint we keep our focus on strong national champion banks and low-risk institutions such as in the UK always focusing on banks with large capital buffers to withstand potential earnings volatility. The regions we prefer are the UK (national champions and building societies), Italy (national champions), Spain (national champions and some smaller banks), which all remain areas of focus. On the other hand, Germany, France, Netherlands and Switzerland look less compelling to us. In Germany we see excessive SMEs and CRE exposure, while in France valuations still look relatively unattractive. We also find US financials unattractive due to relatively tight spreads for the larger institutions and weak fundamentals in the regional banking universe. On single instruments, we favour shorter-duration products in order to manage recession risks and the potential impact on credit spreads in case economic growth will slow down. At this stage we see limited spread pickup in longer expected maturities as credit curves remain relatively flat. We favour high reset bonds due to higher resiliency at times of stress with the upside of potentially higher coupon in case of extension (non-call).

Luca Evangelisti shares his views on the fallout from the collapse of the 3 US Regional Banks and Credit Suisse and identifies the opportunities he sees within the asset class.

Contingent Capital 2023 Mid-Year Outlook: Down but not out

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Luca Evangelisti Investment Manager & Head of Credit Research, Fixed Income

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FIXED INCOME OUTLOOK: H2 2023

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The inherently asymmetric risk profile in bonds is something that all market participants must keep in mind, however, and indeed can work strongly in the favour of active investors as detailed due diligence should help avoid defaults. Credit selection key to returns What we’ve seen already in the first half of this year is greater dispersion in credit spreads, with the market punishing bad news and unbalanced capital structures, particularly in the lowest quality CCC-rated end of the spectrum, and an increased risk of accidents leading to a default such as the case of the US regional banks. This is where the work of experts in credit selection can really pay off, getting under the hood of issuers to understand where their vulnerabilities may lie and whether or not investors are being appropriately compensated for the risks they’re taking. Right now my preference is to avoid companies where cash flow is coming under pressure, and particularly those that may see interest costs increase substantially either because they hold significant floating rate debt on their balance sheets or because they have significant near term debt maturities that will likely be refinanced at much higher interest rates. While acknowledging that the ‘recession vs. inflation’ debate is still unresolved, my own preference is for resilient companies that are less cyclically exposed. As highlighted above, in the current environment of very elevated yields, investors can earn such attractive levels of income whilst retaining moderate risk positioning in terms of credit selection and duration, that there is no need to own more challenged credits. The various arguments about the likely path of growth and interest rates could be debated for hours – but I believe the macro data does not provide enough evidence to make a definitive call either way. For example, while global manufacturing data has been very weak, it is still difficult to unpick the profound effects of the pandemic which saw significant pressures on both the supply and demand side. Furthermore, the tightening of lending standards that was evident in the latest US Senior Loan Officer Survey and ECB Bank Lending Survey is consistent with increased recessionary risk, but labour markets in the US, Europe and the UK remain exceptionally tight. This labour shortage grants workers significant bargaining powers, driving elevated levels of wage growth that may ultimately reignite inflation. To illustrate this point, in the US wage growth already exceeds headline inflation meaning that workers are experiencing real-terms pay increases. The recent upside surprise in US GDP has led to increased speculation that a soft landing may be possible in the US. In my view, any soft landing would in any case not be a position of stable equilibrium – in other words, the ‘softness’ might be short-lived, turning into either a stickier inflation scenario or a recessionary one depending on the development of labour market conditions. In general the environment is uncertain, but with yields high and various tools at investors’ disposal to manage downside risk through both duration exposure and credit selection, this is an environment where actively-managed strategies can shine.

The atmosphere in fixed income markets remains one of elevated uncertainty, as investors grapple with twin risks. On the one hand, headline inflation is coming down across developed markets (albeit at different speeds), but in general wage growth remains high and labour markets are tight – will this result in upward pressure on inflation again towards the end of the year? On the other hand, the rapid tightening that we’ve seen from developed market central banks is probably only now feeding through into the real economy – could this trigger a recession, perhaps a severe one, which would be a powerful deflationary force? Focus on what we do know Fortunately, amid this uncertainty, bond investors can take comfort in something we can know: yields are currently high relative to history (see chart below) across both investment grade and high yield credit. This represents an attractive carry trade, with investors being ‘paid to wait’ for the macro situation to develop, while simultaneously offering upside potential if the rate cycle does decisively roll over. What is more, bond investors have some built-in downside mitigation in the case of recession. In a recessionary environment, spreads typically widen – however it is likely that some of this widening will be delivered through falling government bond yields, thereby reducing the negative impact on total returns. Put another way, yields are so elevated, that they provide a substantial cushion to a move wider in yields, whether in response to recessionary fears or inflationary ones. It is also important to remember that yields are attractive even at the short end of the curve, meaning that investors can source income with only a moderate level of duration risk, consequently containing sensitivity to interest rates. Adding shorter-dated bonds at attractive yields can therefore act as ballast for a diversified fixed income portfolio.

Hilary Blandy describes how fixed income markets must weigh up competing risks on rates and inflation. Amid this uncertainty, however, bond investors are paid to wait.

The twin risks facing bond investors

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Hilary Blandy Investment Manager, Fixed Income

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FIXED INCOME OUTLOOK: H2 2023

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Jupiter’s fixed income capability benefits from the expertise of a large team of Credit Analysts, who devote themselves to understanding the subtle dynamics of individual sectors, as well as conducting detailed due diligence on issuers and individual issues. Their work is closely integrated with that of our investment managers, influencing credit selection across all Jupiter’s fixed income strategies. Here, we look at their latest insights from three sectors. REAL ESTATE SECTOR Leon Wei, Credit Analyst, Fixed Income Real estate continues to be a sector where we see pockets of interesting opportunities. The end of loose monetary policy and the accompanying rapid rise in interest rates have placed pressure on the real estate sector as a whole, where previously elevated property valuations are now on a downward trend, and many issuers within the sector no longer have the unimpeded access to cheap debt financing they used to enjoy. Consequently, this has led to high degrees of investor pessimism towards the sector, sometimes creating opportunities particularly from a credit perspective. Since late 2022, during several bouts of market volatility, we have seen lowly-levered and fundamentally defensive investment grade real estate bonds trading at levels akin to high yield credits and have taken advantage of some these opportunities in situations where we see superior risk/reward. From a credit selection perspective, we favour real estate issuers with great degree of financial flexibility, typically supported by ample liquidity, high levels of unencumbered assets, and manageable maturity profiles. We also pay close attention to the underlying issuers’ earnings stability and level of fixed rate debt within the capital structure, which tend to inform the issuers’ ability to generate free cashflow. Relating to governance, we prefer issuers with supportive shareholders, as well as those issuers exhibiting creditor-friendly behaviours. Positively in this regard, in recent months, several of the companies in which we invest have made announcements to repurchase their own bonds at steep discounts, which are credit accretive. Overall, we continue to remain selective and fundamental-focused within the space, and we view real estate as a sector which could benefit, should the world eventually enter a falling rate environment. TELECOMMUNICATIONS, MEDIA & TECHNOLOGY Andrew Rubins, Credit Analyst, Fixed Income We believe that the Telecommunications, Media, and Technology (TMT) sector currently offers attractive investment opportunities in Fixed Income. Although it’s a broad sector, our favoured opportunities tend to be concentrated in telecommunications, specifically, fixed broadband and mobile providers. We find the defensive nature of this sub-sector, its strong fundamentals and stable and / or improving cash flow generation, despite heavy investment cycles, as attractive characteristics. We prefer companies operating in mature, developed markets, like the UK, the Netherlands and France, where operators behave rationally, user bases are large and customer churn is relatively low, as well as those operators in more emerging markets, like countries in Eastern Europe, where operators are experiencing faster growth, driven by increasing ARPUs and penetration. We prefer the secured bonds of those companies that own their infrastructure assets, such as the cable / fibre network, towers, or data centres, amongst others, which are valuable and provide strong asset coverage at relatively low leverage points. The tranches of these bonds tend to be large and liquid, aiding our flexibility in trading these names. Finally, digitalisation is more important than ever because businesses urgently need to innovate, reconfigure, and transform in response to dynamic market conditions and emerging technology, such as artificial intelligence, which again provides attractive investment opportunities. HEALTHCARE SECTOR Andrew Rubins, Credit Analyst, Fixed Income The European Healthcare sector currently offers attractive investment opportunities in Fixed Income, in our view, even though it’s made up of many different industries from pharmaceuticals, biotechnology and devices to health insurers and hospitals. Generally, the sector is supported by several fundamental near- and long-term growth drivers including an ageing population in both developed and emerging markets, an increase in age-related diseases, the global reach of disease, increasing demand from the younger population due to more active lifestyles, personalised medicine, technological advances in surgery, materials, 3D printing, shifts to outpatient settings, smaller players gaining market share and accelerated growth driven by postponed but not cancelled surgeries over COVID-19. From a credit perspective, this diverse sector has proven to be stable, resilient, largely anti-cyclical and defensive in nature. We target those companies with visible growth drivers, high margins, and strong cash flows. We prefer to invest in the debt of businesses that benefit from high trading multiples and low leverage, which imply large equity cushions and offer downside protection. Sub-sectors that we favour include laboratory / testing businesses, specialty pharma, and medical devices. We have also targeted certain special situations where companies are in a turnaround phase, rationalising their portfolios, improving operations and their balance sheets and deleveraging. Historically, the sector has been one of the strongest performers in late cycle and recessionary periods, which is why we like it at this juncture amid uncertainty over the broader macroeconomic outlook.

Jupiter’s fixed income capability benefits from the expertise of a large team of Credit Analysts. Here, we look at their latest insights from three sectors.

The credit analysts’ view

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Leon Wei Investment Analyst, Fixed Income

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FIXED INCOME OUTLOOK: H2 2023

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Andrew Rubins Investment Analyst, Fixed Income

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