The headwinds for high grade bonds from excessive rates volatility and higher primary market activity, combined with the decline in monetary aggregates, are expected to moderate in 2023. As we have moved well into the rate hiking cycle of major central banks and await to see some traction on inflation rates, we expect rates volatility to gradually subside and find more stability in sovereign bond markets.
IG credit spreads have historically shown a high degree of correlation with volatility in interest rates under different monetary policy regimes. This has been even more observable now, since the aftermath of the pandemic, with credit spreads widening as central banks grew more hawkish and rates volatility increased . As central banks slow the pace of rate hikes we believe that rates volatility will normalise, providing a catalyst for IG credit spread tightening. Lastly, as yields rose significantly and duration has decreased in IG corporate bonds, this space now offers a much higher return buffer against a further adverse movement in yields.
Going into 2023 we remain cautious on rates until we see repeated positive signs on inflation or a pivot in central bank rhetoric with weaker economic data. As the market eventually shifts focus from rates volatility to growth scarcity, we expect IG to outperform in 2023 as the decompression in HY versus IG becomes a more prominent theme in bond markets.
With regards to sectors, we have a preference for non-cyclicals given the better risk-return trade-off when considering the weakening macro backdrop. The spread basis of cyclicals versus non-cyclicals is at the tighter end of the range since the great financial crisis across single-A and triple-B rating cohorts, even when excluding the energy sector, which has outperformed strongly in 2022.
We expect credit spreads in cyclicals to come under widening pressure, with weaker global demand and higher costs weighing on margins. However, we continue to see value in energy names given that current energy price levels will continue to support high cash flows and credit quality improvements in the sector. We also find that financials may offer value on a selective basis following the relative underperformance in 2022. Banks’ profitability is expected to remain supported by higher interest rates.
At the other end of the spectrum, we are seeing headwinds picking up for issuers particularly in utilities given the rise in energy prices and the regulatory pressures to defer cost increases to end consumers. Real estate has also been suffering from the sharp rise in interest rates. Given that the risks of an energy crisis are more acute in Europe, we expect downward revisions in earnings expectations to accelerate in line with the deterioration in manufacturing and services PMI for the region. We see the risk of a faster decline in fundamentals and credit metrics to be higher for European corporates, which could lead to disappointment across debt and equity investors.
Given these reasons, we prefer to tilt our bond allocations in favour of US-based IG corporate bonds. However, due to the underperformance of euro-denominated credit and the resulting attractive valuations, we find Reverse Yankees (i.e. euro-denominated bonds issued by US issuers) to offer “the best of both worlds”, and hence we are comfortable being overweight such securities based on this selection. We anticipate mid-single-digit returns in IG corporates (EUR hedged), with carry returns being the main positive contributor to performance given the substantially higher starting yield levels, while we also see some scope for returns from spread tightening depending on the depth and duration of a central-bank-induced cyclical downturn.