Morgan Stanley IM: European Short Duration – An asset class for an uncertain world

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• The prospect of less hawkish central bank policy should be supportive for short duration assets in 2023: With signs that inflation could be trending lower, policy and short-term interest rate uncertainty is expected to decrease as Central Banks pivot to a more balanced policy mix focused on growth and inflation.
• Historically, higher yields have provided investors a much better starting point to generate positive absolute returns: We believe higher yields should provide investors with more ‘carry’ and a better cushion against further credit spread widening and/or interest rate volatility. In addition, both government and credit curves flattened in 2022. The net result is that short duration high quality bond yields are at levels that can help meet investor goals without the need to extend duration or increase credit risk.
• Corporates entering 2023 from a strong position: Issuers are going into the year with defensive business models, strong liquidity, optimised costs from the covid era, and leverage that recognises the risk to profitability in 2023. We do not expect a spike in default rates.
• Credit Valuation: The widening of credit spreads in 2022 reflects the widening of swap spreads as well as weaker credit markets. We expect credit spreads to remain range bound above long run averages reflecting current macro uncertainties. Tighter swap spread and carry should be a driver of returns with government bond yields and credit spreads at attractive levels. Expect sector dispersion and outperformance from financials

2022: A sharp rise in yields

After more than a decade of low inflation and low growth that allowed for 'easier' monetary policy (low/negative interest rates coupled with quantitative easing programmes), central banks were forced to aggressively tighten monetary policy in 2022 in response to persistently high, supply-side driven inflation. The subsequent market moves in government bond yields and credit spreads have shaped a strong argument for short duration fixed income strategies.

The yield on a 2-year German government bond was 338 basis points higher, rising from -0.62% to 2.76%. The credit spread of the Bloomberg 1–3-year EUR investment grade corporate index rose 73bps from 65bps to 138bps. The yield of that very same index rose 4.1%, increasing from -0.01% to 4.09% (see Display 1)

DISPLAY 1 2022: Sharp move higher in short duration yields

^{Source: Bloomberg, as at 31st December 2022. Index refers to Bloomberg Euro Corporate Bond 1-3 Year Index. The index is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See Disclosure section for index definitions.}

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^{RISK CONSIDERATIONS}

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^{There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in a portfolio. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. They are also subject to credit, market and interest rate risks. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, and correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Due to the possibility that prepayments will alter the cash flows on collateralized mortgage obligations (CMOs), it is not possible to determine in advance their final maturity date or average life. In addition, if the collateral securing the CMOs or any third-party guarantees are insufficient to make payments, the portfolio could sustain a loss.}