This article first appeared in Capital, The Edge Malaysia Weekly on January 23, 2023 - January 29, 2023

FIXED-income fund managers are anticipating a turnaround in the bond market after a bruising 2022, during which most bond indices in developed markets saw negative returns amid high inflation and corresponding interest rate hikes by central banks.

“Overall, it was a challenging year for the global bond markets in 2022, with Malaysia not spared from the sell-off as central banks globally tightened their monetary policies to contain the high inflation driven by the Russia-Ukraine war and disruptions to supply chains,” Jesse Liew, chief investment officer for fixed income (Asean) at Principal Asset Management Bhd, tells The Edge.

It is widely believed that the US Federal Reserve may raise its target rate by another 25 to 75 basis points (bps) this year, while Bank Negara Malaysia is expected to raise the overnight policy rate (OPR) by another 25bps to 50bps.

It is worth noting that Bank Negara paused its interest rate hikes at its monetary policy committee meeting last week, at which it had been expected to raise the OPR by another 25bps. The central bank raised the OPR four times last year, by a total of 100bps, to 2.75%.

In the US, the Fed raised interest rates seven times, by a total of 400bps to 4.25-4.5%, in 2022.

“This could turn out to be a better year for bonds as the global inflation trend appears to have peaked. Central banks would be less pressured to further tighten their monetary policies beyond the aforementioned levels, especially in the face of a potential slowdown in the global economy. This backdrop would provide a supportive case for bonds to perform better in 2023, as the current market bond yields have already priced in the hikes by central banks,” says Liew.

Bloomberg data shows that the US dollar’s losses have continued since last October, while the euro has responded in tandem, appreciating 12% during the period.

Dr Ray Choy, head of economics and research at Opus Asset Management Sdn Bhd, points out that as inflation eases, the market can expect the Fed to pause its rate hikes in the second half of 2023 (2H2023). He notes that the 10-year US Treasury yield is expected to range between 3.4% and 3.8% amid the decline in attractiveness of the US dollar.

“It will provide further headwinds to Malaysian bonds, given the global markets’ appetite for carry,” he says, noting that the local currency is trading near the initial target of 4.40, with further positive policies by the new government and an emerging markets’ rerating on US dollar weakness seen to support ringgit-denominated assets.

To Franklin Templeton head of Malaysia Hanifah Hashim, higher interest rates imply that fixed income can finally deliver income again, with attractive risk-return profiles in some segments of the asset class, particularly those with short durations.

“While we anticipate that volatility will persist and risk assets have the potential for further downside, given our view that spreads still do not fully reflect an economic slowdown or contraction, we are more positive on the prospects for fixed-income investments than we have been in some time. We feel that a selective, research- and fundamentals-based approach can allow us to identify interesting opportunities,” says Hanifah.

“We believe benchmark yields in the US have more room to rise as we expect the Fed funds rate to peak at the 5% to 5.5% range. But as they near this peak and technical conditions stabilise, more investment opportunities will arise.

“We are cautious on US Treasuries because markets seem to be pricing in what would be a significant reversal of rate hikes already in 2023, which we do not see as plausible. Opportunities should appear sooner on eurozone government bonds as valuations appear attractive and European Central Bank hawkishness should peak soon.”

Hanifah recommends three themes on which to focus when it comes to global fixed-income investments this year.

“[First,] stay in high-quality liquid assets. We continue to believe high-quality, shorter-duration assets will outperform and provide greater protection from potential fundamental weakness and market sentiment-driven volatility,” she says.

“At the shorter end of duration on most fixed-income instruments, investors are now being paid handsomely to hold more liquid segments, and higher-quality assets should remain more resilient in the face of a challenging macroeconomic environment and economic slowdown. We anticipate 2023 will have significant bifurcation, with higher-quality asset classes and issuers being favoured over weaker ones, which will continue to face increasing difficulties.”

Second, Hanifah advises investors to be prudent in order to “protect against rising yields, which are still below their ultimate peaks”.

“Be cautious with duration, however, as yield levels become increasingly attractive and interest rate hike cycles end, opportunities will arise. It may be a matter of quarters, or maybe months, where these opportunities will present themselves,” she notes.

Third, Hanifah urges investors to keep dry powder ready amid improved prospects for fixed income. She explains that the yields being generated have become more attractive and fixed-income assets should once again provide defensive characteristics in an economic slowdown amid a slower pace and magnitude of interest rate hikes.

“We will continue to take advantage of market dislocations to add selective risk exposure and be ready to deploy capital as we gain greater clarity on the trajectory of US monetary policy and the extent of the global growth slowdown,” she adds.

For Principal Southeast Asia, bond portfolios had begun “a strong run since 4Q2022, driven by expectations of a rate-hike pause by major central banks as they assess global economic dynamics”. Liew believes the Fed’s reaffirming its stance to keep interest rates high in 2023 may weigh on economic fundamentals and possibly shift portfolio risk positioning towards bonds.

“Looking at the US economic data and the yield curve, there are clear signals a recession is coming. The fact that the market has not reflected this yet suggests it is a good time for investors to tactically reposition their portfolios into fixed income,” he points out.

“One of the biggest investment lessons in 2022 is that no investment style works all the time, especially when the financial landscape has changed dramatically,” says Liew, noting that the traditional 60:40 allocation to stocks and bonds failed last year in the face of a stronger US dollar.

He explains that the “negative correlation between the two asset classes broke down due to the high inflationary conditions, which facilitated the aggressive tightening in monetary policies by central banks, causing risk assets to post negative returns”.

Liew says parts of the global market, such as local currency bond strategies, were able to generate positive returns owing to “lower rate hike increases as well as a decent absolute yield position”. “Markets with a lower tendency for sharp policy rate shifts and higher absolute yields will stand out as more resilient in a volatile rising interest rate environment,” he explains.

Liew adds that rising interest rates and the expected slowdown in the global economy could be a double whammy for corporates this year, eroding profit margins and weakening their debt-servicing ability.

“Should a sharp contraction in the global economy occur, we expect credit spreads to widen from their current levels, which are now trading below long-term averages, and we expect corporate bonds to underperform government bonds under this scenario,” he explains, adding that on the local front, Malaysian credits are well placed to withstand rising interest rates and a global slowdown, due to relatively strong balance sheets.

“While we do expect some margin erosion due to cost pressures, we think corporate defaults and downgrades will be well contained, compared to the previous two years,” he says.

Besides placing more pressure on corporates, the slowdown in economic growth can also cause credit spreads to widen from their current levels, says Hanifah.

“[Therefore,] we still prefer to move up in quality on US investment-grade issuers. We are also cautious on US high-yield issuers, although here, we see very interesting longer-term prospects given the already attractive yields and favourable technical conditions,” she explains.

Franklin Templeton tends to be more bullish on European investment-grade corporates given their “strong fundamentals, with a bias to higher-quality credits, as well as European high-yield corporates, given the attractive carry”.

Hanifah believes that other sectors that were strongly challenged in 2022 —like municipal bonds, emerging-market sovereign debt and emerging-market corporates — will present attractive opportunities as the monetary tightening cycle matures.

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