Looking towards 2024, we remain positive on short dated sterling investment grade credit with there being attractive opportunities in both yield and credit spread terms. As credit investors, one of the biggest opportunities that we have is the additional yield that we earn over Gilts, the ‘credit spread’. Currently, the yield premium in short-dated (1-5yr) sterling corporate bonds over benchmark Gilts is 153 basis points, which gives us an additional tailwind to performance.1
It's hard to predict the future, although it seems inflation is declining and each additional data print reinforces that. However, with growth looking anaemic, we’re teetering along the edge of a recession, which makes our conviction around defensive fixed income much higher than risky assets.
There’s been much talk about the lack of transmission between higher rates to the real economy, but we’re now starting to feel the effects of the initial rate hikes. We’re moving towards late-cycle dynamics, with rates remaining high and credit conditions tightening. We’re seeing this through an increase in the level of volatility and dispersion within individual equities and credit spreads. This transmission mechanism will likely continue through 2024 and probably beyond that. With an inverted yield curve, there’s a unique opportunity for investors at the short end of the curve to add yield and take less risk.
Assessing potential risks ahead
A potential surprise in the market could come from the ongoing geopolitical backdrop. There are multiple conflicts globally that could tip over into broader regional conflict which could have serious implications for markets. We do think there should be some risk premium, given the geopolitical uncertainty surrounding the potential of involvement of various state-actors in the situation.
Furthermore, there could be a surprise to the market if inflation remains stickier than expected. With the market already pricing in cuts for next year, an uptick in inflation (which could potentially come from shocks associated with geopolitical risks) could push yields back up again. Fortunately, under this scenario, short-dated bonds may outperform longer-dated bonds as they are less sensitive to interest rate risk.
A winning formula
We aim to generate alpha by delivering an excess yield over the index, which primarily comes down to active credit decisions, and this is how 2023 has panned out with the bulk of excess return coming from our excess yield over the index. This excess yield is largely achieved via three strategies; being underweight the highest quality quasi-sovereign and supranational names, adding selectively in callable financials and taking very conservative high yield exposure (capped at 10%).
From a single-name perspective, some of our high conviction names in the secured space have supported alpha such as AA, Center Parcs and Telereal (secured on BT telephone exchanges). Our excess yield and such single-name selection will remain key for 2024.
As big debt maturity walls loom in 2025 and 2026, we have allowed our high-yield exposure to run down and out of the portfolio. Refinancing and default risk among these more indebted businesses looks likely to rise as conditions tighten. We believe high yield offers a relative lack of compensation in spread terms versus investment grade credit, where our preference is for defensive sectors such as secured bonds and utilities. We’ve reduced portfolio credit beta by shifting credit exposure to the shorter end of the curve too, switching out of 2028 maturity bonds into 2025 maturity bonds from the same issuers, for example.
