Key takeaways

• The relatively low yields provided by government and investment grade corporate bonds do not provide much cushion for the volatility that could occur in 2022.
• While we do not expect significant disruption to the economic recovery, we think investors should look to maximise the yield they can potentially receive relative to the risk required.
• We believe the risk/reward profile of the high yield asset class remains a bright spot in an otherwise low-yielding/tight-spread world for government and corporate bonds.

No pain, no gain. At least that's the old saying. But portfolio management is a well-developed science of managing risk, of finding large or small opportunities that - when combined in a diversified portfolio - may produce a little bit more return with the same risk as a passive benchmark, or the same return with a little less risk. Or, ideally, some combination of both. As such, portfolio management is the science of finding as much gain with as little pain as possible and, in our view, 2022 is likely to be a year where active portfolio management could shine.

If the second half of 2020 was an environment where a bond investor wanted as much corporate credit risk as possible (taking advantage of hugely dislocated valuations because of COVID-19), we think that opportunity largely ran its course in 2021. Investment-grade corporate bond spreads could tighten further by the end of next year. But if they do, it is more likely to be modest than not. And if they don't, the relatively small yield they offer does not provide much return for the risk tolerance such a position requires. When the Bloomberg US Aggregate Bond Index is offering a yield of just 1.7%,¹ it just doesn't take much of a rise in interest rates or a widening in corporate bond spreads to risk giving it all back.

Corporate fundamentals remain robust

This doesn't mean we aren't positive on the outlook for the US economy, and select pockets of the corporate bond universe. We are. Broadly speaking, corporate fundamentals are still strong in aggregate, with consensus earnings-per-share (EPS) growth estimates for the S&P 500® Index near 7.5% for the next 12 months.² And, historically, corporate bonds have performed well during the early part of a US Federal Reserve (Fed) tightening cycle. In 2016 and 2017, for example, the Bloomberg US Corporate Bond Index returned 6.1% and 6.4%, respectively.³ It wasn't until toward the end of the tightening cycle, in 2018, when performance suffered, and the index fell 2.8%.⁴ However, current valuations suggest this effect may already have been anticipated. Because, despite the recent uptick to near 1.0%, spreads of the Bloomberg US Corporate Bond Index remain near historical tights.⁵

But if investment grade corporate credit has, historically, performed well during the early part of tightening cycles, the high yield market has been even more impressive. In 2016, for example, the Bloomberg US High Yield Index returned 17.2%,⁶ which makes some intuitive sense. After borrowing substantial sums when official interest rates were relatively low (and they were 0% in 2020 and 2021), many companies' liquidity profiles improved significantly. Now, flush with cash and the expectations that income could potentially remain strong on the back of a still-recovering economy, more companies have begun a process of repairing their credit profiles.

High yield bond spreads, like investment grade corporate bond spreads, may also be pricing in much of the good news. But high yield is different in that the significantly higher yield the index pays is meant to be compensation for defaults. And the outlook for defaults has rarely looked so good. The current "stress ratio" (that is, the number of bonds trading below 80 cents on the dollar), which can be a great indicator of default rates, has improved dramatically in recent quarters. Indeed, we believe corporate bond defaults peaked in early 2020 and expect they will decline further in 2022. Simply put, when defaults (pain) are expected to be low, the relatively high yields (gain) being offered deserve the attention of active portfolio managers. While it helps that the Fed, as recently as 2020, signalled it would support the high yield market should a major crisis occur, we think the asset class' risk/reward profile remains a bright spot in an otherwise low-yielding/tight-spread world for government and corporate bonds.

In our view, volatility in the high yield market is more likely to come from external, macro factors than from concern about any individual sector or company. The Fed is expected to begin an interest rate tightening cycle next year and while that is usually cause for caution, the recent surge in inflation and the uncertainty about how fast it may fade are likely to add to the uncertainty. Volatility should also be expected from both good and bad news regarding the COVID-19 virus. On the one hand, news like Pfizer's COVID pill is cause for celebration, while the emergence of the Omicron variant is more concerning. Most importantly, we expect volatility in 2022 - whatever the cause - may have an outsized impact on returns, given how low government and many corporate bond yields are today.

This is not to suggest that investors should rethink their overall allocation to bonds. On the contrary, we believe a core allocation to bonds can often play an important role in reducing the volatility of an investor's overall portfolio. But with yields as low as they are, more - and more active - portfolio management, in our view, is needed. As we do not believe the Fed beginning to raise interest rates or new variants of the COVID-19 virus will add enough uncertainty to derail an economic recovery of the magnitude we see across the globe, we think investors should stay invested in bonds. But some diversification would help, and - where fundamentally appropriate - favouring higher yielding securities may help thicken the yield cushion against future volatility.

¹Bloomberg, as of 3 December 2021.
²Bloomberg, as of 8 December 2021.
³Bloomberg, as of 8 December 2021.
⁴Bloomberg, as of 8 December 2021.
⁵Bloomberg, as of 3 December 2021.
⁶Bloomberg, as of 3 December 2021.

Credit spread/spread: The difference in yield between securities with similar maturity but different credit quality, eg, the difference in yield between a high yield corporate bond and a government bond of the same maturity. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing spreads indicate improving creditworthiness.

Default: When a bond issuer fails to meet their repayment obligations to bondholders. The default rate measures the percentage of defaulting bonds within the defined market over a set period.

Fundamentals: The information that contributes to the valuation of a security, such as a company's earnings, its financial strength or the evaluation of its management team, as well as wider economic factors.

High yield bond: A bond that has a lower credit rating than an investment grade bond. Sometimes known as a sub-investment grade or speculative grade bond. These bonds carry a higher risk of the issuer defaulting on their payments, so they are typically issued with a higher coupon to compensate for the additional risk.

Investment grade bond: A bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments. The higher quality of these bonds is reflected in their higher credit ratings when compared with bonds thought to have a higher risk of default, such as high yield bonds.

Monetary policy/stimulus/tightening: The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money. Monetary stimulus refers to a central bank increasing the supply of money and lowering borrowing costs. Monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money.

Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility.

Yield: The level of income on a security, typically expressed as a percentage rate.

This information is issued by Janus Henderson Investors (Australia) Institutional Funds Management Limited ABN 16 165 119 531, AFSL 444266 (Janus Henderson). The funds referred to within are issued by Janus Henderson Investors (Australia) Funds Management Limited ABN 43 164 177 244, AFSL 444268. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested. Past performance is not indicative of future performance. Prospective investors should not rely on this information and should make their own enquiries and evaluations they consider to be appropriate to determine the suitability of any investment (including regarding their investment objectives, financial situation, and particular needs) and should seek all necessary financial, legal, tax and investment advice. This information is not intended to be nor should it be construed as advice. This information is not a recommendation to sell or purchase any investment. This information does not purport to be a comprehensive statement or description of any markets or securities referred to within. Any references to individual securities do not constitute a securities recommendation. This information does not form part of any contract for the sale or purchase of any investment. Any investment application will be made solely on the basis of the information contained in the relevant fund's PDS (including all relevant covering documents), which may contain investment restrictions. This information is intended as a summary only and (if applicable) potential investors must read the relevant fund's PDS before investing available at www.janushenderson.com/australia. Target Market Determinations for funds issued by Janus Henderson Investors (Australia) Funds Management Limited are available here: www.janushenderson.com/TMD. Whilst Janus Henderson believe that the information is correct at the date of this document, no warranty or representation is given to this effect and no responsibility can be accepted by Janus Henderson to any end users for any action taken on the basis of this information. All opinions and estimates in this information are subject to change without notice and are the views of the author at the time of publication. Janus Henderson is not under any obligation to update this information to the extent that it is or becomes out of date or incorrect.

Don't be fooled by an Index

We've become accustomed to global equity indices marching in one direction - higher. The S&P 500 is sitting near yet another all-time high and valued at 21x forward earnings, with the index up 23% calendar year to date, you may assume it's been a great year for all US stocks.

As the index has moved higher only 50% of stocks are above their 200 day moving average. In fact, just five stocks - Microsoft, Alphabet, Apple, Nvidia and Tesla - account for 35% of the S&P's year to date return, and more than 50% of the S&P's return since April. The same five stocks account for over 70% of the NASDAQ's 18% return year to date.

Global equity indices are near all-time highs but fewer and fewer stocks are taking us higher. The market is crowding into an increasingly narrow subset of stocks - big cap tech. Reliance on the performance of a handful of names is not a backdrop conducive for markets to continue rising; it's typically associated with market draw downs, as shown below.

                     

Source: Factset, Antipodes

The market is ignoring some major changes taking place in the economy
 

November's headline inflation print of 6.8% brings the 12 month rolling average to 4.2%. Assuming no adverse outcomes from Omicron (find our latest podcast discussion on Omicron here) and supply chain constraints are ultimately alleviated, there's a pipeline of inflationary pressures building via wages, rent and energy prices which can keep inflation above trend over 2022.

Wages in the US are rising 5% p.a., meaningfully higher than the historical average of 3% p.a, and the labour market is tightening. The number of Americans filing for unemployment benefits recently fell to the lowest level in 50 years and the US Federal Reserve (the Fed) forecasts the unemployment rate will fall to 3.5% by the end of next year, which is below the long-term average.

On the ground, the annual increase in asking rents has been running at more than 10% higher for the last few months versus the 3.8% yoy captured in the latest CPI report. This is thanks to the low-interest rate fuelled property boom in the US where house prices are accelerating at the fastest pace in 15 years, which feeds into rent with a lag.

And finally, energy prices remain elevated. European gas prices have been extremely volatile recently reaching $29/unit - a level around three times higher than prior peaks. Europe is facing a once in a multi-decade energy supply crunch. Larger than expected drawdown of inventories with no increase in supply in sight means that demand rationing will likely need to continue throughout the winter. Meanwhile in the US, the gas price has recently corrected by over 30% to under $4/unit on account of warmer weather which has driven down near-term residential demand. But this could easily reverse. Over the longer-term energy prices can remain structurally higher even with decarbonisation because hydrocarbons have seen supply rationed. Companies are investing below replacement cost levels.

Sticky inflation and a tighter labour market has seen the Fed scrap the use of "transitory" in relation to inflation and recently accelerated tapering to $30b per month, meaning the Fed will no longer be buying new issuances of Treasury debt after March 2022. While there's no explicit timing for rate hikes the market has priced in one rate hike by June 2022 and three hikes by the of the year taking the cash rate to 0.75%.

So, what does this mean for bond yields? As conditions tighten, coupled with a relatively resilient outlook for economic growth (even with the pace of growth slowing) is it reasonable for yields and discount rates - the rate used to value a company's future cash flows - to remain at historically low levels? As yields/discount rates have collapsed earnings multiples have risen. Higher yields will be a meaningful headwind to weaker companies that are valued at unsustainably high multiples.

In fact, this may already be playing out. The bottom quartile of the NASDAQ (based on 1 year performance) - arguably the weaker expressions of growth - is around 30% lower than its 1-year highs versus the NASDAQ index itself which is only 6% off its 1-year high.

INTRODUCTION

The focus on ESG, sustainable investing and investment stewardship has dramatically risen in recent times. However, 2020 marked a significant turning point.

Prior to COVID-19, while considerations of ESG and sustainability had become prominent, progress remained slow. However, the emergence of COVID-19 in combination with extreme events triggered by the climate crisis heightened global focus on ESG matters and starkly highlighted the challenge before us all.  A perfect storm had been brewing fueled by habitat destruction, biodiversity loss and social inequality. In addition, as the COVID-19 crisis has unfolded, millions of people crashed down through Maslow's Hierarchy of Needs, revealing the widespread nature of social inequality and insecure work practices.

Given the systemic weaknesses that were unveiled and the broad-based issues facing society, it became rapidly evident (even to the naysayers) that all participants in the investment supply chain have a role to play, including sovereign bond investors.  We need to build in greater levels of system strength and resilience (economically, environmentally, and socially) as we collectively recover from COVID-19.

THE GROWING ESG TREND IN FIXED INCOME - NOT JUST A THEME FOR EQUITIES

Historically, ESG focus has largely been on equities: this was a space where asset managers and asset owners felt comfortable and had clarity around what they could do and how to do it. Attention has also evolved to similar areas of comfort: real assets (property and infrastructure) are asset classes where the what, why and how of ESG is readily understood.  

In the mind of many investors, fixed income tended to be obscured, as it perhaps felt less tangible and therefore more difficult to tackle from an ESG perspective. However, the focus has now duly turned to fixed income.  This is critical, in that when we consider the capital stack, global debt markets (~$281T in size at the end of 2020) are almost triple the size of global equity markets (~$105T), yet almost all ESG focus has been in the listed equity space, leaving a large gap in approach (and potentially outcomes and impact).

In the context of fixed income, greater emphasis has tended to have been placed on corporate debt. The reason being that much of the ESG and investment stewardship knowledge, and practical experience, garnered in and from public equity markets can be transposed into how one approaches ESG in public debt markets - from issuer ESG analysis through to engagement.

Whereas, in the context of sovereign debt, it may have been conceptually overwhelming to know where to focus, e.g.:

• How to engage with a sovereign counterparty or influence change when it comes to ESG.

• Government activities are broad in nature, some of which may be detrimental from an ESG perspective, others which are either neutral or positive.

INTEGRATING ESG INTO SOVEREIGN BOND INVESTMENT  

Notwithstanding, the focus is now turning to sovereign bonds.  This is important given the size of the sovereign debt market which accounts for roughly two thirds of total fixed income market capitalisation.  Further, we all have a role to play in driving positive change and delivering impact on the ground. We also believe that the ESG and investment stewardship lessons learned in public equity markets and listed corporate debt can be elegantly leveraged in a sovereign debt context.

Consideration of ESG factors has long been part of, and an input into, JCB's investment decision making process as a means by which to manage risk, make informed decisions and influence positive change.

We have continued to further refine and develop our approach, which is now centred around three core pillars of focus, namely:

1. ESG research and integration

2. Active ownership

3. Collaboration and information sharing

Sovereign debt investors, JCB included, have utilised ESG research and integrated ESG considerations into their investment analysis and decision-making processes for some time. While ESG factors may not drive the ultimate investment decision, they provide another lens by which to view a prospective investment opportunity. This goes to making well informed investment decisions.

In addition to this, when thinking about ESG integration, ESG factors are not only relevant as an input but can be a key output. The market has witnessed an exponential rise in green, social and sustainable debt issuances. This provides investors with an opportunity to finance impactful activities, projects and programmes at a sovereign and semi government level. Further, such issuances also "serve as a commitment device for politicians".

Government policies and commitments can always be watered down or resiled from, however:

"...when a finance ministry creates a green-bond programme and builds out a "green curve", backing out of specific policies may become harder...Doing so would hurt liquidity and anger investors." ["A wave of green government bonds is flooding markets", The Economist, 9 October 2021].

Anchored to the need for ESG integration and investing in impact, is the opportunity (and some may say obligation) to:

• Engage with issuers and other relevant parties

• Collaborate with others to influence change

Engagement and collaboration, in the context of ESG and investment stewardship, have long been the domain of listed equity investors. However, this is evolving, and sovereign debt investors increasingly recognise that they also have a role to play.

Historically, it has been posited by some that it is not appropriate for sovereign debt investors to utilise their ownership rights and engage on the basis that it may be construed as undue political influence. Our view is that such engagement is incumbent upon us as a responsible market participant, and it provides a constructive tool to:

• Communicate our approach and client expectations

• Share our key focus areas and encourage action

• Communicate our desire to see the development of more sustainable and resilient financial systems

• Maintain ongoing dialogue and conversations regarding ESG related issues

Accordingly, we are in the process of increasing our levels of engagement with issuers, originators, and other market participants as a means by which to stimulate ongoing dialogue and where possible influence for positive change regarding ESG matters. We firmly believe that having conversations can create awareness and drive positive change.

Related to active ownership, we are also seeing that the appetite to collaborate (e.g., via the PRI) has risen.  JCB has recently joined the PRI as a signatory and is actively looking for ways in which to collaborate with others to influence positive change. This will also be an area of ongoing focus.

WHAT ARE THE OPPORTUNITIES FOR INVESTORS?

There are opportunities and benefits for sovereign bond investors who are integrating ESG and focused on participating in the Green Social and Sustainable (GSS) bond space. Specifically, consideration of ESG factors leads to better informed investment decisions, and when combined with the tools of active ownership, it provides such investors with the capacity to influence positive change.

In addition, investing in labelled sovereign GSS issuances enables the delivery of real impact on the ground. In doing so, it also provides the ability to ensure that such Government commitments to positive GSS projects and outcomes are executed on irrespective of the political cycle.

Consideration of ESG factors and investment stewardship practices, combined with participating in GSS issuances also ensures that portfolios are better aligned with client expectations and outcomes, and provides a source of portfolio diversification.

CONCLUSION

We are witnessing a maturation in ESG practices combined with the ever-growing need for capital markets to influence positive change from a social and environmental perspective. Given that sovereign debt constitutes a large part of the capital stack, sovereign investors such as JCB have a role to play in building in economic and ecosystem resilience. Particularly given that against the backdrop of COVID-19 the awareness of the intersectionality between environmental and social issues and capital markets has amplified.  More is now rightly being asked of all capital market participants.

Ultimately, as an active sovereign debt investor, we feel that ESG is both an important input and output of the investment management process.

If you are interested in learning more about how sustainable investing works, view our ESG Approach to investing.