Last year’s Mini Budget caused a crisis in the UK gilt and liability-driven investment market. Professional Pensions asked five investment managers to discuss the impact on their asset class and the broader macro implications over the past 12 months.
Neuberger Berman EMEA CIO for multi-asset Niall O'Sullivan
Gallons of ink have been spent on the lessons learned about the dangers of and suitability of collateral. However, it is also worth thinking about the wider macro implications and lessons.
In the context of a world with large budget deficits and debt to GDP levels, the UK was potentially the "canary in the coal mine" of the dangers of losing the confidence of the bond vigilantes. While other countries may not have the "accelerant" of a LDI framework, the painful lessons learned in the UK are being absorbed globally.
Secondly, when the stability of the repo system came into question, as a result of the potential for defaults, the central bank was prepared to pause its tightening activities to protect the system. A similar pattern of behaviour by the Federal Reserve was observed in the aftermath of the Silicon Valley Bank crisis. These actions suggest that the so-called "Central Bank Put" remains, at least when the stability of the global financial system is called into question.
These lessons have wider applicability than just the UK and are a consideration for global portfolios.
RBC BlueBay Asset Management securitized credit portfolio manager Tom Mowl
Plenty has happened in securitized credit markets in the past year. Alongside the initial secondary market supply shock that pushed credit spreads wider, the LDI crisis has also had lasting effects on the buyer base that has changed the demand dynamics.
While credit spreads have recovered to sit slightly inside where they were pre-LDI, the path was certainly not linear, with securitized credit not immune from volatility following the US regional banking crisis and the takeover of Credit Suisse. What's for sure is that the last year presented plenty of attractive investment opportunities for active asset managers. But, more importantly, where do we go from here? There are still compelling opportunities to be found across securitized credit markets as primary supply and the shift in demand has kept credit spreads in certain sectors attractive - both on a historical basis and relative to other fixed income asset classes. As the chart shows, September has seen a big increase in primary market issuance, whereas this time last year secondary markets were the dominant force. This technical pressure on valuations coupled with the fact that Securitized Credit offers significant cushion against an increase in defaults - very important in what remains an uncertain macro-economic environment - means that Securitized Credit continues to provide an attractive investment proposition.
Source: Morgan Stanley data. Sep 2023 data is estimated
Polen Capital head of US high yield and portfolio manager Dave Breazzano
When gilt spreads spiked during the LDI crisis of late September 2022, risk-off sentiment spread across debt markets. The US high yield market, often influenced by outside forces, was not immune. Of note, high yield market spreads widened sharply. However, since that tumultuous week, spreads in the high yield market tightened considerably.
Source: ICE. High yield market represented by the ICE BofA U.S. High Yield Index.
Events like the gilt crisis create angst; however, authorities are quick to action and often calm investor concerns about the most recent emergency. Those mini crises aside, for more than a year now US high yield investors have been bracing for a recession. More recently however, those fears have ebbed. Nowhere is this more evident than in the CCC-rated segment of the high yield market which has seen a significant tightening of spreads in the past year.
Going forward, we believe the next 12-months will look very much like the last, unpredictable. There continues to be uncertainty about a recession, even though investors have become increasingly sanguine about the possibility. Our best guess is that a recession may come sometime next year. However, we should remember it has been one of the most telegraphed recessions in history, hopefully providing businesses and investors time to prepare accordingly.
Royal London Asset Management head of rates and cash Craig Inches
The LDI crisis was a wakeup call for leveraged investors, and as a result we now live in a world where supply needs to find the correct clearing level to seek investor demand. The politicians who started the fire have also been reminded that financial markets are a taskmaster of good fiscal discipline and if the powers that be step out of line they will be severely punished.
This paints a very interesting picture as we head into another 12 months of heavy supply and political jousting. The pension LDI community are largely in tidy-up mode as the majority prepare for insurance buyouts generating less demand for longer-dated UK debt. The Debt Management Office is aware of this and appears to have front loaded its long-dated and index-linked supply.
Elections usually result in some giveaway goodies to try and sweeten the prospect of voting for the incumbent. However, this will prove much more difficult with the market keeping an eye on fiscal prudence in a high-inflation, high-supply environment. With the prospect of an increase in quantitative tightening looming, it could be difficult for the Chancellor to be creative, but desperate times call for desperate measures which may create further gilt market volatility in 2024.
Gilt supply in the year to date
TwentyFour Asset Management portfolio manager Elena Rinaldi
The UK mini-Budget period was one of the largest liquidity events the European asset-backed securities (ABS) market has seen since the GFC, characterised by wholesale selling by asset managers on behalf of pension fund clients.
In those three weeks, the volume of ABS and collateralized loan obligation (CLO) bonds sold via auction totalled €6.9bn (£6.02) (we estimate bilateral sales of equivalent size), roughly equivalent to the volume seen in H1 2022.
The LDI crisis put ABS in the spotlight, but what happened next? Firstly, we believe that the ABS market stood up to this test: with UK pension funds receiving liquidity, and absorbing an unprecedented level of supply that would challenge most markets, though outcomes likely differed by asset manager.
Secondly, it highlighted the depth of investor base, where we feel buyers sensed a liquidity driven opportunity whilst being confident on credit risk.
ABS spreads have tightened slowly in 2023, but yields have grown through floating rate coupons adjusting upwards in step with risk-free rates. As default risk grows in focus, bankruptcy remote, defensive ABS bond structures will be increasingly important drivers of the ABS outperformance versus broader fixed income market.
With central bank rhetoric centred around "rates higher for longer", we believe that ABS investors can expect to benefit from high and stable income while the credit defensiveness will offer greater credit certainty should a hard landing materialise.
Source: Citi Velocity; 31 August 2023
Vontobel portfolio manager Carlos de Sousa
Emerging market (EM) fixed income has a had a decent run this year, but the asset class has lost some of its absolute return lately. Year-to-date hard currency EM bonds delivered total returns between 3% and 3.7%, while local-currency EM bonds are up by 5.5%. That's not bad compared to +1.5% delivered by global aggregate fixed income, particularly in an environment of recession fears and rising rates.
Fixed income has been challenged in the last couple of months by an expectation that central banks will have to keep interest rates elevated for longer than previously thought. Yet, the reason of this higher for longer is rather a positive one. It's not that inflation is sticker than previously thought, on the contrary, there's been good progress on disinflation at a global scale. The reason is that the US economy has been much more resilient than expected and a soft landing is now the market consensus. This is bad news for fixed income in the short term but it's good news for EM in the medium term, as the risk of recession and spread widening has diminished while carry has become even more attractive.