Financial conditions are tightening – what comes next?
After a strong rally across financial markets in January, for fixed income investors February was a nasty throwback to the sort of market conditions that battered the asset class in 2022. Having returned 3.3% to deliver its best ever January since inception in 1990, the Bloomberg Global Aggregate Bond Index – a widely used benchmark that tracks the performance of global investment grade bonds – then posted -3.3% to deliver its worst ever February.
A combination of factors contributed to this swing in performance, in particular stronger-than-expected economic data out of the US, which has seen investors start to take the Fed’s hawkish stance more seriously and revise their terminal rate expectations upwards; the 10-year US Treasury yield has now ticked above 4%, having been just under 3.4% a month ago. After a frantic January of issuance the primary market also remained wide open for business, with US investment grade supply setting a new February record and new bond supply in Europe 38% higher than at this point last year. While many deals in February were oversubscribed and performed well in secondary, indicating that there are still healthy levels of cash on the side-lines, towards the end of the month we started to see some indigestion and more mixed performance. In European investment grade, for example, 15% of deals printed in February are either unchanged or trading wider in secondary. We have seen a similar moderation of post-issue performance in high yield, where sentiment has likely been impacted by US high yield fund outflows of $6bn last week, the third largest weekly withdrawal on record.
At the start of February we wrote that investors hadn’t missed the rally in fixed income, given yields were still elevated despite improving sentiment as inflation data continued to trend downwards and Europe’s energy crisis eased. It will come as no surprise then that we think the February pull-back has only improved the buying opportunity. We still believe conditions today are far better than they were when yields were higher in Q3 2022, when there were still material unknowns and we had far less clarity than we do now on many of the issues that plagued 2022.
Valuations looked very appealing coming into 2023, and February’s pull-back has presented investors with another opportunity to take advantage of what we think are still attractive yields.