Active Bond Management in Less Liquid Markets
What happened last week?
- The S&P 500 lost -0.267%
- The Dow Jones fell -2.99%
- The Nasdaq composite shed -3.33%
Volatility in the bond market in 2022-2023 has created potential opportunities in actively managed fixed income strategies.
We’re still erring on the side of caution in fully invested portfolios, seeking to earn investment grade bond and dividend income to generate returns even as markets speculate about a return to bull market conditions that we think seems premature.
3 Things to Know
Bond headwinds vs hedge fund performance in 2022
Portfolio returns in 2022 and early 2023 have been volatile and painful for many public market investors. An unprecedented degree of correlation between equity and bond markets diminished the apparent value of portfolio diversification, leaving cash as a favored asset class last year. Fixed income investors saw the Bloomberg Aggregate Global Bond Index lost 11.2% with US Treasuries returning -12.5% in 2022.
In 2022, hedge funds, on average, preserved capital better than passive equity and fixed income strategies. In this instance, the alternative asset class fulfilled its intended role within portfolios by providing diversification from traditional markets, particularly in Relative Value and Macro strategies.
Even more directional strategies such as Event-Driven and Credit hedge funds outperformed the broader bond indices.
Higher rates and Fed tightening are curtailing demand for new issues
As we begin 2023, a powerful combination of higher rates and quantitative tightening has curtailed demand for new debt issues. This is reflected in their pricing often being divorced from company fundamentals.
In 2022, spreads for new issue B/B+ loans peaked at 510bps in July, yet dropped to 457bps by December, even as the Fed pressed on with rapid policy tightening. During the third quarter of 2022, leveraged credit markets effectively closed as banks found they had no buyers for the loan commitments they signed in the first and second quarters. This led to downward pressure on asset prices as banks struggled to syndicate their loans.
Given such severe syndicated debt-issuance constraints, many companies will need to explore alternative ways of raising capital and extending debt maturities in 2023 and beyond. The divergence between public market investors — like ETFs and Collateralized Loan Obligations — and private market buyers has created a notably favorable landscape for alternative managers seeking to capture better risk-adjusted and absolute returns relative to published bond indices.
Why it’s a bond picker’s market
Given the sensitivity of mutual funds and CLOs to fund flows and ratings downgrades, prices of poorer quality bonds often get hit disproportionately.
The outflows from high yield retail bond funds have totaled $38.2 billion since the beginning of 2021. Spooked by this credit and liquidity shakeout amid an uncertain outlook for corporate profits, certain capital markets have largely closed to some companies wishing to raise capital.
What does this mean for investors?
For investors, the absence of bank lending, lower ETF and CLO purchases and concerns about corporate profits going forward, have created a series of related opportunities. In our view, this is a time when opportunistic alternatives managers can use their expertise to underwrite loans and pursue event-driven strategies in both public and private credit markets. Managers who have insight into issuer quality and potential capital structure events — including refinancings, debt exchanges and outright restructurings — may be able to generate strong total returns.
See our weekly CIO Strategy Bulletin for more details