2023 Fixed Income Outlook

What is your fixed income outlook and recommended strategy for 2023?

We believe 2023 will be a good year for fixed income. The easy trade would be to buy bonds on every sell-off as bonds should perform well when recession is close. Market should stay volatile in 1H23, offering good opportunities for building up positions gradually. We prefer to stay away from HY credits in 1H23, and lock in high interest rate and wide credit spreads of good quality IG bonds whenever possible.

For bond positioning, we prefer investment grade over high yield, because:

1.  First, we still expect 2023 to be fairly volatile. So it’s better to stay defensive with IG credit. On an absolute yield basis of 5-6% vs. long-term historical average of 3.6%, IG bonds still look fairly attractive to real money and PB investors, so we expect some good technical support.

2.  Second, IG credit spread is still wider than its historical average, and we see room for spread compression. While HY credit spread is wider, we remain concerned with its high probability of default. Fed will likely keep rates at high levels for 2023, which will easily turn into liquidity pressure for many HY issuers.

Tenor wise, we prefer 3-5 year, because we prefer to start with the short end to the belly and then gradually add longer duration. Currently, the futures market still expects the Fed to cut rates in 2H23. We think this is too optimistic, as we expect no rate cut until 2024. Given how inverted the yield curve is, we see better risk reward with the short end and do not suggest to go too aggressive on duration yet.

What is your bond top pick for 2023?

We have three top picks – European bank papers, HK corporate perpetual, and short dated floating rate structured products.

First, We like European and UK bank senior and tier-2 papers. We believe a lot of negative news such as recession and Ukraine-Russia tension has already been priced in. Risk reward is attractive relative to their credit fundamental. European banks have good track record in weathering recessions and financial crises throughout the last few decades. Most of them have very good asset quality and strong balance sheets. The higher interest rate will also improve their profitability to offset NPL.

Second, we like HK corporate bond for their strong fundamental and long operating track record. The story is simple. If they have been around for decades, we don’t see why they would not continue to do so. Among the HK space, we like HK corporate perpetual the most. They have retraced ~20pts in 4Q22 due to some geopolitical and policy concerns. These concerns, such as zero covid policy, are gradually fading, but bond prices haven’t fully recovered yet. At a low cash price of 50-70 level, we believe downside for these HK corporate perpetual should be quite limited, even if UST10 moves unfavorably.

Third, we like short dated floating rate or fixed-to-floating structured products for the purpose of portfolio balancing. Black swans are always a possibility, and investor should not put all their eggs into one basket and solely bet on long-dated fixed coupon bonds for rate compression. For example, if you hold a lot of fixed coupon perpetual bonds, you may want to add some short dated floating rate structured products to balance your portfolio’s interest rate and duration risks.

What could be the key risks for investors to look out for?

Default risk. 2023 will likely be the year where Fed slow down and pause the rate hikes. Having said that, despite the pause, interest rate will still be maintained at a pretty high level, which could easily turn into liquidity and refinancing pressure for weaker issuers. Funding flexibility will reduce. Meanwhile, a weakening economy will also pressure issuers’ operating cash flow. With both bond issuers’ funding access and operating cash flow being adversely impacted, we expect default probability to remain high in 2023, especially for weaker HY issuers. We therefore suggest investors to remain cautious and stay defensive with good quality IG bonds instead of HY bonds.