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    GSAM Insights

    NAVIGATING FIXED INCOME IN 2023

    Navigating Fixed Income

     

    December 2022  |  8 Minute Read

    Bring on Bonds

    The late Brazilian racing champion Ayrton Senna once said: “You cannot overtake 15 cars in sunny weather, but you can when it’s raining.” For investors, there has been no shortage of downpours in recent years. Successive shocks—the Covid pandemic, war in Ukraine, surging inflation, and aggressive monetary tightening—have been layered onto each other while fast-tracking long-term themes such as digitization, deglobalization, destabilization in geopolitics and decarbonization of the global economy.

     

    The multiple headwinds have created a challenging investment environment and an age of volatility. Stormy times can lead some investors to step off the racetrack to look for shelter in cash. Others, however, are adjusting to volatile conditions and stepping up—or considering—investments in fixed income. Following the sharp rise in yields in 2022, attractive income and total return potential could potentially be greater than it has been in a decade (Exhibit 1). Put simply, we believe 2023 is the year for investors to Bring on Bonds.

     

     

    Exhibit 1: Higher Yields Presents Attractive Income and Total Return Potential Across Fixed Income

     

    Top Chart Source: Bloomberg, Macrobond, Goldman Sachs Asset Management. As of December 15, 2022.

    Bottom Chart Source: Bloomberg, Macrobond, Goldman Sachs Asset Management. As of November 2022. The Bloomberg US Aggregate Index is a broad-based benchmark of the investment grade, US-dollar denominated, fixed-rate taxable bond market. It includes US Treasuries, corporate bonds, MBS, ABS and CMBS.

     

     

    Stay Selective

    We are in a new era for financial markets—one without easy policy to lift all assets. In our view, this is fertile ground for generating alpha through active security selection. We already see evidence of higher dispersion in fixed income markets (Exhibit 2) which we expect to rise further as borrowers adapt to slower economic and earnings growth, as well as a higher-for-longer inflation and rate environment.

     

     

    Exhibit 2: Capture Yield Selectively Given High Macro Uncertainty and Growing Dispersion

     

    Source: Macrobond, Bloomberg, Goldman Sachs Asset Management. High quality fixed income universe includes investment grade bonds (developed and emerging market corporates as well as credit derivatives) and AAA-rated CLOs. As of December 14, 2022.

     

     

    Mind the Tails

    Our central scenario assumes growth, inflation, and the pace of monetary tightening all slow in 2023. But in a world of continuous shocks and a wide range of possible outcomes, we think it is important to invest around scenarios rather than specific outcomes. Specifically, we are prudent about managing downside risks from inflation and recession, but we are also opportunistic about capturing upside from volatility and positive scenarios such as a US soft landing and China reopening.

     

    Heading into 2023, we see value in high quality short duration bonds where returns tend to turnaround before an end in the rate hiking cycle. For retail investors, lending to high quality companies or governments for a short duration of time—while capturing higher yields—is an attractive alternative to still-low savings rates on bank deposits. We also think assets that stand to benefit from lower rate volatility appear attractive, namely, investment grade (IG) bonds and agency mortgage-backed securities (MBS). As evidence of normalizing inflation and improving growth becomes clearer, we think there will be an opportunity to add exposure to cyclical assets such as high yield (HY) credit and emerging market (EM) debt.

     

    We see two key tail risks to our outlook. The first is prolonged monetary tightening amid resilient labor markets (perhaps due to labor hoarding) and persistent inflation. This could lift rate volatility and precipitate capital losses if yields move higher. But we think high quality fixed income still looks attractive in this scenario due to higher real and nominal yields relative to the past couple of decades. The second is a hard landing—or severe recession—driven by the lagged impact of past tightening or fresh shocks. This scenario would weigh on risk assets such as high yield credit, leveraged loans and EM debt. Across 24 major economies, 80% already have manufacturing PMI readings below 50—a rare observation outside global recession.1 However, we think government bonds, particularly short-dated bonds, would rally in this scenario (in anticipation of policy easing). We also think high quality fixed income such as agency MBS would prove resilient due to its low cyclicality. IG credit may also perform well, particularly bonds issued by companies in defensive sectors with healthy balance sheet positions and more limited profit margin pressures. More broadly, our exposure across fixed income spread sectors exhibits an up-in-quality bias to guard against this tail risk.

     

    The two tail scenarios are intrinsically linked; recession risks are driven by monetary tightening and so it is hard to be confident that recession has been avoided until the end of tightening is in sight. This ultimately means that the inflation rate will remain a key datapoint into 2023. But as noted, with yields and dispersion higher, we think fixed income offers more opportunity than it has in a decade.

     

     

    Exhibit 3: 2023 Roadmap

     

    Source: Goldman Sachs Asset Management. As of December 14, 2022. For illustrative purposes only.

     

     

    Strategic Opportunities

    More broadly, we think higher yields represent a good entry point for strategic investors in all fixed income markets, including EM corporate and sovereign bond markets where idiosyncratic risks have masked broader resilience. We also expect continued expansion of the green bond2 market as issuers raise capital to finance investment needed to advance the energy transition. As green bonds are issued by companies from more sectors and sovereigns from more regions, the green bond market will evolve into a more diverse investment opportunity set. This will allow investors to consider green bonds as a core component of their overall bond allocations. Overall, we think 2023 has potential to be a promising year for fixed income total returns, particularly in the context of the post global financial crisis era.

     

     

    Key Investment Views

    IG credit

    Constructive but selective given rising dispersion

     

    A sharp rise in yields in 2022, particularly in short-dated IG bonds, presents a promising outlook for total return. Higher carry suggests excess returns will turn positive in 2023, though the first part of the year may remain volatile given recession risks. The fundamental picture may weaken from a strong starting point as sticky inflation, high rates and slower earnings growth generates greater dispersion. However, high macro uncertainty may keep traditional late-cycle activities, such as debt-fueled M&A activity, in check. This is ultimately supportive for IG balance sheet positions suggesting any uptick in credit rating downgrades—following two years of positive ratings momentum—will be modest.

     

     

    HY credit

    Constructive but selective given rising dispersion

     

    Spreads appear wide relative to the fundamental backdrop. We think the default rate will likely edge higher from rock bottom levels but remain below historical averages given strong corporate balance sheets and limited near-term refinancing needs. Further, credit quality in the asset class has improved (due to a wave of fallen angels from the IG market in 2020) and the technical backdrop is balanced. That said, we are defensive and up-in-quality in our exposures given slowing growth.

     

     

    Leveraged loans

    Modestly constructive and mindful of risks among loan-only issuers

     

    We believe attractive yields compensate for downside risks; however, our exposures are up-in-quality given the deteriorating growth backdrop. In particular, notwithstanding limited near-term refinancing needs and some hedging of floating rate exposure, we are mindful of the impact of a higher funding cost environment on loan-only issuers.

     

     

    US Agency MBS

    Modestly constructive given attractive valuations and low cyclicality

     

    Having entered 2022 with historically tight spreads owing the Fed purchases, the agency MBS markets exited 2022 with the widest spread level outside of the Covid stress period and the global financial crisis. We think lower rate volatility combined with lower new supply will help performance turnaround in 2023. Further, low cyclicality makes the asset class—which has limited credit risk owing to its implicit or explicit government guarantee—attractive in an environment of decelerating growth.

     

     

    Securitized credit

    Constructive given attractive carry

     

    We think high carry is attractive considering high levels of credit enhancement in high quality securitized sectors such as collateralized loan obligations (CLOs), given this provides credit support for senior bonds into a weakening cyclical backdrop. We think spreads will tighten in 2023 owing to robust fundamentals for underlying loans and a muted new supply picture.

     

     

    EM sovereign bonds

    Modestly constructive and mindful of idiosyncratic pockets of weakness

     

    We think it may take time for value to be unlocked in distressed external EM bonds given lengthy debt restructurings; however, we expect higher yields in resilient sovereigns to offer opportunities generate positive total returns. Meanwhile, we see select opportunities in local EM bond markets as central banks near the end of their hiking cycles and consider monetary easing. Overall, we are paying close attention where sovereign bond restructurings have potential to progress or where economic fundamentals are not reflected in market valuations.

     

     

    EM corporate bonds

    Constructive EM corporate bonds which we view as a bright spot in the EM universe

     

    We believe EM corporate bonds are a high-quality source of yield that can offer diversification benefits for global corporate bond investors. Further, EM corporate credit metrics appear well positioned for macro headwinds. Meanwhile, we think Asia HY yield—a subset of the broader EM corporate bond market—may experience stabilization following record defaults in the China Property HY sector, incrementally constructive housing policy developments and a departure from zero-Covid restrictions.

     

     

    US municipal bonds

    Constructive with an up-in-quality bias

     

    With IG municipal bond yields almost double the past decade average, we expect a positive demand technical to support the sector in 2023. We do not foresee a material uptick in rating downgrades or defaults as a strong starting point for fundamentals should see municipal bonds demonstrate resilience into a slowing economy. We have an up-in-quality bias given attractive spreads in IG sectors. We also think BBB-rated and HY bonds offer attractive risk-adjusted return potential, but selection is key given the complex macro backdrop.

     

    Source: Goldman Sachs Asset Management. As of December 16, 2022.

     

     

    Fixed Income Snapshot

     

    Source: Macrobond, Goldman Sachs Asset Management, ICE BoFAML and J.P.Morgan. As of December 30, 2022.

     

     

     

     

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    1 Source: Goldman Sachs Asset Management, Macrobond. Based on PMI data as of December 7, 2022.

    2 Green bonds are standard fixed income securities with a green element. Their financial characteristics such as structure, risk and return are similar to those of traditional bonds. The main difference is that the money raised is used exclusively to finance projects or activities with a specific environmental purpose.

     

    Disclosures

    Risk Considerations

    Mortgage-related and other asset-backed securities are subject to credit/default, interest rate and certain additional risks, including extension risk (i.e., in periods of rising interest rates, issuers may pay principal later than expected) and prepayment risk (i.e., in periods of declining interest rates, issuers may pay principal more quickly than expected, causing the strategy to reinvest proceeds at lower prevailing interest rates).

    Collateralized loan obligations (“CLOs”) involve many of the risks associated with debt securities, including interest rate risk, credit risk, default risk, and liquidity risk. The risks of an investment in a CLO also depend largely on the quality and type of the collateral and the class or “tranche” of the CLO. There is the possibility that the strategy may invest in CLOs that are subordinate to other classes. CLOs also can be difficult to value and may be highly leveraged (which could make them highly volatile). The use of CLOs may result in losses.

    Emerging markets investments may be less liquid and are subject to greater risk than developed market investments as a result of, but not limited to, the following: inadequate regulations, volatile securities markets, adverse exchange rates, and social, political, military, regulatory, economic or environmental developments, or natural disasters.

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