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Fixed income
Fixed income

2023 Spectrum outlook

A year of opportunity for preferred and capital securities

January 10, 2023
L. Phillip Jacoby
Chief Investment Officer of Spectrum Asset Management
Joe Urciuoli
Executive director and head of research, Spectrum Asset Management
Full spectrum of opportunities illustration

We believe the global financial sector is fundamentally sound and well-positioned to manage through weak economic conditions in 2023. Due to record-high inflation and rising interest rates, financial conditions tightened in 2022; while high inflation is expected to subside in the United States, the lagged effects of fiscal tightening will continue to slow growth or induce a recession in 2023.

All eyes will be on the Federal Reserve (Fed) as it draws its aggressive rate-raising campaign to an end in response to slowing inflation. While the Fed still has some lifting to do and will hold rates high but stable long enough to hold a positive real federal funds rate for some time, we expect rate increases to end by mid-2023. Additionally, the Fed plans to substantially trim its balance sheet so liquidity will be tested as the Fed pivots away from being the buyer. The Fed’s tools only impact the demand function while the supply function is private, global, and precarious.

Global geopolitical risks such as the continuation of the Russia-Ukraine war, energy shortages and challenging economic conditions across Europe, changing credit cycles, and recessionary conditions are among the most elevated threats going into 2023. China’s social and economic systems are hampered by zero-COVID-19 lockdowns while European countries reliant on Russian gas, namely Italy and Germany, must find substitutes to fill the gas deficit.

We believe the outlook is positive for hybrids in 2023 – credit fundamentals are sound, yields are high, and prices are low, making a compelling case for high-quality preferred and capital securities for those looking for exposure to credit and duration. Additionally, hybrids can be capital defensive as predominant fixed-to-refixed types will reset coupons, elevating prices from today’s deep discounts. Increasing fears of missing out should make any credit corrections in 2023 shallower and shorter-lived than of those experienced last year.

United States

The U.S. Treasury markets might face technical challenges next year, but the Fed’s high-for-longer policy should keep real yields elevated and long-term rates channeled between 3.5% and 4.5%. This should not be a runaway bull market next year but rather a range-bound market of opportunities. Tightening financial conditions and slow-to-negative global GDP growth will likely raise credit losses in 2023 but should not materially impact high-quality hybrid issuers. However, the rate of defaults for more vulnerable high-yield credits might pick up in 2023.

Of the U.S. Treasury debt held by the public, 58% ($13.8 trillion) will mature and reprice within the next four years. In effect, 82% of the entire U.S. Treasury market ($19.4 trillion) will reprice in the auction process within the next four years. The Fed needs to be aggressive in anchoring inflation as close as possible to its 2% long-term objective because refunding the Treasury market could create a massive overshoot on interest expense if rates stay high for too long.

Europe

Due to a stoppage of gas flows by Russian President Putin and economic sanctions imposed on Russia, many European countries are facing a potential energy crisis as prices spike and a deeper recession compared to the U.S. in 2023. Market reforms are needed to help lessen dependency on Russian gas through the buildout of additional low-cost clean energy infrastructure, but Europe should be careful not to exacerbate headline inflation and sovereign debt burdens in addressing the gas void.

In late 2022, Italy elected Giorgia Meloni as prime minister. Though relatively inexperienced, she will have to tackle decades of economic stagnation, high debt, and the long-standing problem of an aging population resistant to needed reforms like making the country less protectionist and more competitive.

Germany and Italy are each expected to face economic contraction in 2023 due to their reliance on Russian gas. Moody’s estimates that the G-20 advanced economies will decline from 2.1% in 2022 to 0.2% in 2023.

Implications for junior-subordinated capital securities

Spreads for both the preferred securities market and large-cap contingent convertibles) are as wide as they were during the past two economic cycle downturns (2015-2016 and 2018-2019) while hybrid yields are still higher than any time since the European sovereign debt default.

With high yields and low prices, hybrid yield opportunities against the backdrop of strong credit fundamentals appear very strong for 2023, especially if equity markets slide due to the Fed substantially trimming its balance sheet and stepping out as a buyer. Hybrid yields and spreads are compelling, so we believe income should more than offset the capital risks of rising rates or widening spreads. Further, in this market environment, hybrids can be capital defensive. Predominant fixed-to-refixed types will reset coupons from the 4% area up within a 7-8% range just a few years from now, elevating prices from today’s deep discounts. From a relative perspective, hybrids are very attractive (net of inflation and net of historical default).

Heat map of the real yield matrix comparing hybrids to corporates

Source: Bloomberg, ICE BofA Bond Indices. As of November 30, 2022.
1 Inflation assumption based on the UST 5-year breakeven inflation rate.
2 Default assumption based on Spectrum's 10-year annual default study through 2020.

As loan quality holds, banks to focus on digital offerings and regulation in 2023.

Though the transition to a post-COVID-19 economy has been bumpy, banks’ loan quality and profit performance remained supportive. Even with inflation pressuring corporate and retail clients alike, loan quality has held, and the higher interest rate environment has boosted most banks’ crucial net interest income. In 2023, we expect loan quality to normalize further but with no systemic worries about serious loan quality difficulties.

U.S. consumer-friendly regulation will continue to be the norm with both revenue (such as loss of overdraft fees) and cost (higher fines) implications. Banks will also be focused on digital product and service initiatives involving meeting client needs, reducing costs, and competing with digital-only banking rivals. Tech-savvy banks have established reputations for trust, and issues in the crypto space, such as the messy collapse of FTX, only reinforce the competitive resilience of banks.

Gradually rising rates are positive for insurers.

Despite market volatility, insurers remain long-term investors in mainly high-grade fixed income, thus rarely needing to monetize losses. While impairments and investment portfolio downgrades can reduce capital, traditional insurers are good managers of asset risks. Macro and related inflationary instability and extreme weather events are challenges for insurers, but major insurers maintain strong balance sheets and underwriting discipline to support customers in 2023.

Gradually rising rates are positive for insurers, though tighter financial conditions have exposed market vulnerabilities such as liquidity challenges in the U.K. pension system due to cash margin calls on derivatives. In contrast, insurers have robust liquidity; abundant capital has safeguarded the property & casualty (P&C) re/ insurance industry from large, weather-related losses since 2017. Firm pricing is helping to offset persistent inflation and potential losses linked to climate change. Inflation remains a key challenge for P&C re/insurers, so we expect strong pricing power to persist in 2023. Reinsurance pricing has lagged but is expected to accelerate in 2023 given more constrained capacity after years of poor earnings.

Key issues for utilities include energy reliability, affordability, and sustainability.

High prices of natural gas, due in part to the lack of Russian natural gas resources, have resulted in commitments from European countries to support citizens and focus on a clean and reliable transition. Government-funded price caps and liquidity measures will continue in 2023, providing near-term support for European utilities.

Compared with Europe’s dependence on Russian gas, the U.S. remains better positioned, but strong regulatory and political tailwinds may be shifting in different jurisdictions. U.S. utilities continue to make record investments, compounding cost pressures. The passage of the Inflation Reduction Act (IRA) may eventually help to mitigate bill pressures as major tax credits/subsidies support the addition of low-cost renewables (wind and solar) and critical infrastructure (transmission and battery storage).

Going forward, we expect utilities to defend their investment grade ratings through greater equity/equity-like funding sources such as hybrids as well as through the sale of minority interests and non-core assets. Utilities may also choose to slow growth in capital spending and shareholder returns from aggressive levels.

ESG’s next phase will include additional scrutiny.

  • Despite setbacks from the energy crisis and political tensions, regulators have not shifted their focus to the importance of ESG (environmental, social, and governance) responsibilities. Regulators in the U.S. and Europe have started to scrutinize sustainable investments more aggressively, tackling greenwashing and “false or exaggerated claims about ESG practices” that may mislead investors.

  • In the U.S., an increasing inflow of capital to ESG products prompted the SEC to propose ESG-related guidelines to identify funds in integration funds, EGS-focused funds, and impact funds. The IRA encourages investment in more nascent clean energy solutions including green hydrogen, renewable natural gas, carbon capture, and small-scale nuclear reactors. The utility industry is one of the few sectors rapidly reducing greenhouse gas emissions. Nuclear power may see a revival longer-term as a near-zero carbon dispatchable solution to balance the intermittency of renewables.

  • In Europe, the Sustainable Financial Disclosure Regulation (SFDR) begins in 2023. European regulators are making progress integrating ESG risks, providing definitions for sustainability, and enhancing reporting frameworks under SFDR. In addition to the classification of Article 6, 8, and 9 funds, the European authorities have developed rules and guidance to strengthen sustainability-related disclosures.

About the author
Disclosure

For public distribution in the U.S. for institutional, professional, qualified and/or wholesale investor use only in other permitted jurisdictions as defined by local laws and regulations.

This material is provided by and reflects the current views and opinions of Spectrum Asset Management, Inc., is an affiliate of Principal Global Investors. Spectrum is a leading manager of institutional and retail preferred securities portfolios and manages portfolios for an international universe of corporate, insurance and endowment clients.

Risk Considerations
Past performance is no guarantee of future results. Investing involves risk, including possible loss of principal. Fixed-income investment options are subject to interest rate risk, and their value will decline as interest rates rise. Risks of preferred securities differ from risks inherent in other investments. In particular, in a bankruptcy preferred securities are senior to common stock but subordinate to other corporate debt. Contingent Capital Securities carry greater risk compared to other securities in times of credit stress. An issuer or regulator's decision to write down, write off or convert a CoCo may result in complete loss on an investment.

Important Information
This material covers general information only and does not take account of any investor’s investment objectives or financial situation and should not be construed as specific investment advice, a recommendation, or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding an investment or the markets in general. The opinions and predictions expressed are subject to change without prior notice. The information presented has been derived from sources believed to be accurate; however, we do not independently verify or guarantee its accuracy or validity. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that the investment manager or its affiliates has recommended a specific security for any client account. Subject to any contrary provisions of applicable law, the investment manager and its affiliates, and their officers, directors, employees, agents, disclaim any express or implied warranty of reliability or accuracy and any responsibility arising in any way (including by reason of negligence) for errors or omissions in the information or data provided.

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