With trillions looking to come off the subs bench is this the year of the bond?
10 min read 29 Apr 24
For bond investors, predicting the timing of a pivot in central bank’s monetary policy cycle can be simultaneously profitable and futile. With both growth and inflation slowing, the direction of travel for interest rates points downwards over the course of 2024, providing a strong tailwind for the asset class and offering an opportunity for the trillions of dollars sat on the sidelines in cash and money market funds to re-enter the market.
Amid a myriad of uncertainties, including prolonged inflation, geopolitical risks and supply and demand dynamics, Harriet Habergham speaks to the specialists across M&G Investments’ fixed income universe to find out whether the investment grade credit space has evolved such that it could deliver returns despite market noise.
Macro: Geopolitics and Trump
Views from Jim Leaviss, CIO Fixed Income, in London and Anthony Balestrieri, CIO Americas, in Chicago.
After two years of negative returns for fixed income markets and the most aggressive central bank hiking cycle in recent history, the tail end of 2023 saw investors rush to the asset class in anticipation of rate cuts in the new year. The fourth quarter rally was an important case study of FOMO (Fear of Missing Out) where investors, not wanting to miss out on capital gains, flooded into the bond market, with the Bloomberg Global Aggregate Bond Index rising 10% from October to the end of the year.
While consensus has been that the direction of travel for interest rates is downwards, economic data continues to send mixed messages, and markets are still eagerly awaiting an initial move from central banks. There is $6 trillion currently sat in money market funds1 (as of February 2024) waiting to be deployed as soon as the speed and strength of cuts becomes clear, and as holding cash becomes less profitable, offering a strong structural support for fixed income markets.
Historically, peak rates signal strong returns for bonds. On average, if you bought a 10-year US Treasury 63 days before the first Federal Reserve (Fed) cut, you would see a 7% capital gain from a 1% fall in yield, plus the carry. However, attempting to time the market is a thankless task and there remain some key macroeconomic risks.
Inflation
The first of these is that inflation is not yet beaten, and a combination of short-term shocks and longer-term structural factors could result in stickier inflation figures than expected.
US Consumer Price Index (CPI) number surprised to the upside in February, rising 3.2% year-on-year, more than the 3.1% expected2. Combined with a resilient jobs market and strong economic data, there are still questions over whether inflation will make its way down to the 2% target.
Even as inflation gradually slows towards target, consumers continue to feel the pressure on their wallets; price levels of everyday items such as rents and food remain substantially higher than before the pandemic. Over the last four years (2019-2023), grocery prices have risen 25% in the US3,4. Not only is this significantly higher than the cumulative headline inflation rate over the period of 19%, but these everyday items are front of mind for consumers; 67% of voters highlight food as the area in which they have been most impacted by inflation5.
With households spending an average of 11.3% of disposable income on food in 20226, price rises of everyday items, such as milk and eggs, have a meaningful impact on consumers’ pockets. However, food inflation is not necessarily dictated by central bank policy, with a combination of factors including labour shortages, supply chain disruptions and climate contributing to sticky price levels. Rents, which make up 35% of the CPI index in the US, are also a contributing factor to more persistent inflation with US rental prices 29.4% higher than they were before the pandemic7.
There are also longer-term structural factors that could result in inflation settling at a persistently higher rate, and consequentially a higher interest rate for an extended period of time.
These include trends such as the green transition, which requires significant capital expenditure and investment, with government policies such as the Inflation Reduction Act in the US and the European Green Deal providing fiscal support.
Other long-term factors which could have inflationary implications include further geopolitical tension, which could result in protectionist policies and increased military spending, as well as demographic trends where an ageing population reduces the tax base, empowers workforces in wage negotiations and creates a need for greater social welfare spending.
'Monetary policy lags can feed through to the real economy in many different ways and for different reasons.'
Recession
While a soft landing – a scenario where inflation falls without a decline in economic activity – has been the prevailing narrative of late, history shows this is very difficult to achieve. Sustained growth, inflation coming down to target and labour markets remaining reasonably strong at the same time is rare; one of those factors almost inevitably starts to wobble.
Inflation has fallen rapidly from a peak of 9.1% in the US in June 2022, to 3.1% in January 2024. Inflation is serially correlated – the best indication of the next month’s reading is the previous month’s. Over the last six to nine months inflation has surprised everybody by the speed and strength of the downward move. There is a risk of central bank policy overshooting, through a combination of higher interest rates and quantitative tightening, as well as supply shocks dissipating.
Investors typically look to the yield curve for an indication of a recession, where an inverted yield curve signifies investors’ expectations that long-term interest rates will decline, normally as a result of a recession.
US Treasury yields have been inverted since 2022, presaging a recession which has not yet transpired in the US. However, it has since flattened as investors price in the first central bank cuts. This would suggest that the likelihood of a recession has receded.
However, it is not unusual for the curve to steepen again before a recession as a result of market pricing in anticipation of a slowdown.
Similarly, if we were to look to market narratives as an indicator of a recession, historically discussions of a ‘soft landing’ often spike shortly before a recession.
Monetary policy lags can feed through to the real economy in many different ways and for different reasons.
Typically, monetary policy can take between four and 29 months to take effect8. Looking, for example, at the labour market, while jobs data appears to show strength on the surface, there are some signs of cooling; February’s data showed the US unemployment rate increased to a two-year high of 3.9%9.
Furthermore, other indicators, including credit card delinquencies which have surpassed pre-pandemic levels10, are starting to show some signs of economic weakness. Meanwhile in January, US retail sales fell 0.8%, versus expectations of a 0.1% drop11, and industrial production also fell12.
Therefore, there is a scenario where we enter an economic slowdown and central banks are forced to cut rates swiftly, acting as a strong tailwind for fixed income markets as investors look to lock in higher yields.
'The UK Gilt Crisis acts as a stark warning for governments seeking to be elected on substantial spending or tax break promises.'
Elections
Adding further uncertainty to the mix, almost half the world’s population are heading to the polls in 2024, including major economies such as the US. The results could have profound long-term impacts on the global economy.
While markets are typically relatively immune to elections, experiencing only short-term volatility, there have been examples in recent years where the actions of politicians or central banks have rocked bond markets.
Liz Truss’s mini-budget in September 2022, resulting in the UK Gilt Crisis, was a notable recent example of how political decisions can spook markets. The episode acts as a stark warning for governments seeking to be elected on substantial spending or tax break promises, but it could also act as an opportunity for fixed income investors.
It is quite rare that euro, sterling and dollar investment grade (IG) fixed income markets move in dramatically different directions, but in the case it does happen, active managers can take advantage of relative value opportunities.
Although at least 64 countries have elections in 2024, all eyes will be on the US Presidential election in November. Despite a strong economy, low unemployment and falling inflation, many voters still feel dissatisfied, with affordability, crime and migration surfacing as top concerns for voters13. As a result, markets should consider the potential implications of a Trump victory.
For example, in 2016, Trump’s election saw bond markets experience a sell off of $1 trillion based on fears over Trump’s spending promises, tax cuts and plans for trade tariffs.
During his last term, Trump cut the federal corporate tax rate from 35% to 21% and has indicated he would lower it further to 15% upon re-election. While initially tax cuts could prove positive for risk assets, they would increase the US debt burden and likely result in a huge amount of Treasury bond issuance, calling into question the US’ debt sustainability.
Other proposed policies include a universal 10% trade tariff on US imports or the “Trump Reciprocal Trade Act”, which would enable tariffs of 100%, both of which could spark an upswing in inflation.
Issuance
Regardless of whether a second Trump term transpires, US government debt issuance is likely to be vast this year with one-third of US government debt due to be refinanced and continued expansionary fiscal policy even during this period of relative economic strength, with policies such as the Inflation Reduction Act and the CHIPS Act adding to the deficit, as well as the overhang from pandemic measures.
A burgeoning deficit when the economy remains strong leaves the US with little fiscal room to manoeuvre in the case of an economic downturn. Furthermore, a wave of issuance could test bond investors’ appetite and potentially have a detrimental impact on sovereign credit ratings, with Fitch downgrading the US from triple-A to AA+ in August 2023.
Having said this, economic principles state that as the quantity increases, price decreases. However, in the case of government bonds, the opposite has tended to be true; there is an inverse relationship between debt-to-GDP and bond yields as governments typically borrow more when the economy is weak, inflation is weak and interest rates are generally falling so bond yields fall.
However, given the extent of borrowing while the economy has been strong, the worry lies in a world where governments borrow more when growth is weak and central banks are no longer buying up vast quantities of government bonds as part of quantitative easing programmes.
However, these concerns may be overblown as only a small part of the overall debt was issued during the low interest rate period following the financial crisis. The majority of the debt was issued at interest rates similar to – if not higher than – those today, meaning the refinancing stress may not be as drastic as might be expected.
Dispersion = opportunities for active managers
Views from Richard Woolnough, Fund Manager, and Gaurav Chatley, Fixed Income Director.
Bond markets as a whole have expanded considerably in recent decades, reaching a total valuation of around $130 trillion14 today, creating a wider and more diverse universe for active managers to take advantage of.
The corporate bond market in particular has seen a dramatic evolution, growing substantially and presenting investors with a huge variety of instruments to invest in today that didn’t exist 20 years ago.
The quantity and magnitude of the change over the last 20 years is remarkable. The investment grade (IG) universe is skewed much more towards being heavily BBB-rated; companies took advantage of lower borrowing costs following the global financial crisis (GFC) to lever up, with little incentive to remain AA- or A-rated.
However, we believe as the cost of borrowing rises, companies will opt to improve their balance sheets. Between 2020 and 2023, there was a net $40 billion of ‘rising stars’ (companies upgraded from high yield (HY) to investment grade), including notable names such as Ford Motor Company, as companies whose balance sheets were in doubt during the Covid-19 pandemic are upgraded. In 2023, there were 14 issuers, totalling 45.88% of market value, that were removed from the fallen angel index (an index of bonds previously rated as IG but subsequently downgraded to HY) as they were upgraded back to IG.
We are seeing this in HY as well; contrasting the HY universe with the IG universe, it is the best quality it has ever been, with data showing that we have never had more BB-rated bonds relative to B- and CCC-rated than we have today.
Dispersion
One result of there being a substantially larger opportunity set is that there’s greater dispersion, where bonds with the same credit rating trade at different credit spreads over government bonds. High levels of dispersion are often found during periods of market volatility such as today and can provide a rich source of opportunities to identify mispriced securities through in-depth credit analysis.
There is a high level of dispersion within BBB-rated bonds meaning that there are significant value opportunities to be uncovered. We believe we can capture higher spreads while taking the same level of credit risk. For example, you can buy a security with a 10-year duration and if spreads were to rally 50 bps, yields were to come down half a percent, that will deliver a 5% capital return. Making these decisions can produce some attractive outcomes for fixed income investors; we often think of equities delivering capital upside, while fixed income delivers the yield on the tin, but for active investors, this does not have to be the case.
Weathering the storm
In the case of a downturn, we believe IG credit is well placed to weather the storm, with strong fundamentals reducing the risk of default.
Looking at default rates in corporate bond markets, markets are pricing in 12% worth of defaults over the next five years for BBB-rated credits – six times more than typically experienced in a five-year cycle and twice the level that was experienced during the GFC.
While we believe default rates will rise, this will be from historically very low levels. In the coming years, we believe default rates will gently rise back to pre-financial crisis levels of 3-4% as a relatively standard long-term average default rate.
Currently, we believe we are being overpaid for the credit risk of BBB-rated bonds; while spreads on a historical basis are currently fairly tight, compared to what you are being paid for default probability, they still appear to offer good value.
This is because balance sheets of IG firms remain strong in our view. Many companies took advantage of low financing costs during the pandemic to refinance and so benefit from a long maturity runway and the short-term risk of having to refinance at higher rates is diminished.
Inflation can also have positive effects on firms indebted at fixed rates; put simply, inflation at 5%, for example, for five years, could reduce their debt by a quarter in real terms.
However, going down the rating scale, there are heavily leveraged companies that are more susceptible to defaults and the compensation for risk falls away. This is where a rigorous credit analysis team is essential, both to take advantage of the opportunities and to avoid the pitfalls. We want to hold IG credit where we believe those specific names and sectors can weather a worst-case scenario storm.
'Markets are pricing in 12% worth of defaults over the next five years for BBB-rated credits – six times more than typically experienced in a five-year cycle and twice the level that was experienced during the GFC.'
Pockets of value
As ever, for those looking beyond market noise and hunting for value, there are underlying issues and sectors which we can benefit from; having a credit research team to conduct the bottom-up fundamental analysis is instrumental in identifying these pockets of value. We see strong opportunities within certain sectors including European financials, certain segments of real estate and emerging market debt.
In our view, European banks are in a positive position today compared to where they have been. We believe there is value, especially within second tier banks within European marketplaces. We see opportunities particularly within those that struggled with balance sheet issues during the financial crisis and had to deal with bad debts and restructurings, as well as operational restrictions. These have benefitted from a strong tailwind in recent years as rates increased, growing their net interest income (NII), and in turn, generating profits.
Furthermore, capital is much higher than it has been and in the years since the GFC, banks have proven themselves to be better able to withstand macroeconomic shocks. While banks continue to be viewed as high beta risky entities, we would argue that since the GFC, regulation has made them safer, better capitalised and well supported by proper risk management, resulting in strong fundamentals.
We also believe there are opportunities within real estate, an area that has suffered somewhat in recent years.
Looking at real estate valuations, the price-to-book of real estate investment trusts (REITs) fell to about 60%. Essentially the equity market was indicating it did not believe real estate valuations, and so spreads began to balloon out. As yields and spreads rose, these highly leveraged companies suddenly found themselves in a position where they could not refinance, and so spreads blew out further.
However, these are specific IG REITs which are the best quality within that marketplace. This trend has been turbocharged by interest rates; once people begin to think interest rates are coming down, valuations will rise back up and refinancing will also become easier. There are companies out there that look like very good value within that sector for a credit research team who can identify where the asset valuations are mispriced.
Emerging market debt saw a strong rally in 2023 but it remains one of the most diversified asset classes within fixed income, offering diversification by region, country, sector, currency and commodity. It also exhibits a high level of disparity from an economic and monetary policy cycle perspective too.
'We see strong opportunities within certain sectors including European financials, certain segments of real estate and emerging market debt.'
You don’t need to make a long-term call, de-risk if necessary and stay nimble
Views from Richard Ryan, Director of Fixed Interest Portfolio Management, and Ben Lord, Portfolio Manager
While the current environment – volatility, uncertainty and the question of where interest rates should be – presents challenges, we believe it is important to look beyond the noise to identify the opportunities in fixed income. We also want to stay flexible to be in a position to invest when the timing is right. The need for skilled investment decision-making in fixed income is particularly acute at this stage of the economic cycle.
Corporate bonds: An inherent hedge?
Investment grade corporate bonds provide natural diversification benefits due to their separate interest rate and credit spread components.
Credit spreads and interest rates typically move in opposite directions, providing a hedge against market movements. For instance, while credit spreads may be expected to widen during a recessionary period as company fundamentals deteriorate, we would normally expect this to be offset by a fall in government bond yields as markets anticipate a cut in interest rates to boost growth. We believe these separate interest rate and spread components can provide a more diversified source of returns throughout the economic cycle.
The asset class has been on quite a journey over the last decade or so with periods such as the Global Financial Crisis, where duration was an investor’s friend, but credit spreads blew out massively and owning credit risk was perceived to be dangerous.
We saw a similar environment in 2020 as the Covid-19 crisis generated a huge amount of uncertainty around how companies would fare; spreads blew out, yields came down and there was an inverse correlation between the two. Conversely, 2022 saw spreads moving wider and yields moving up as well, creating a tough environment for fixed income. We have since had a much friendlier tailwind during 2023 with a huge amount of opportunity to differentiate between those two income streams in credit.
Furthermore, as valuations reprice higher, there is an inbuilt level of protection where yields can rise without a bond investor losing money. As an income producing asset class, prices can fall by the same amount as the income to effectively cover yourself. This is known as a corporate bond breakeven.
With yield and spread curves both flat currently, risk-adjusted returns continue to look more favourable at the shorter end at present.
Be prepared – and stay nimble
Markets are not static; valuations change and continuously reprice. As such while we cannot forecast the future, we can only dispassionately assess valuations today and how much we will be compensated for taking risk. This can act as an important steer as to which segments of the market are attractive.
Markets are not stable, and liquidity is ephemeral; the recent swim into the marketplace has driven spreads tighter, with B- and BB-rated credit at levels we have only seen a few times since the financial crisis.
However, credit spreads can, and do, move aggressively and often without warning. While this can be concerning, we believe this is the prime time when active management pays as cheap markets do not sell off, but expensive markets do; all it takes is a catalyst which the market often fails to see. As such, having the flexibility and foresight to be able to retrench from that risk allows you to take the risk on again when you are in a position to be paid for it.
The most important factor is protecting yourself such that you can come back out to play. The last man standing in the marketplace can capture the bargains. In this scenario, having a fundamental credit research team is essential to identify the most compelling opportunities across global credit markets.
The differentiators
We maintain a positive outlook for fixed income markets as we move further into 2024, with the end of the interest rate hiking cycle offering a strong tailwind for the asset class. However, there continue to be significant risks, including potentially stickier than expected inflation, recession, shockwaves from elections and supply and demand dynamics.
In this environment, we believe flexibility and active management will be a differentiator to capitalise on attractive opportunities. Furthermore, agility and fundamental research will be increasingly important to avoid the pitfalls such a volatile market can bring, maintaining the ability to deploy capital when the risk/return pay off arises once more.
The investment grade (IG) bond market has expanded over the past decade to provide a broader and deeper opportunity set for active managers to invest in, with high-quality IG companies strong enough to weather a potential economic downturn. The concentration of BBB-rated bonds means there is a high level of dispersion for active managers to take advantage of market mispricing, while corporate bonds themselves offer an inherent hedge against potential downturns, in our view.
1Investment Company Institute (ICI), ‘Release: Money market fund assets’,(ici.org), February 2024.
2Bureau of Labor Statistics, ‘Consumer Price Index Summary’, (bls.gov), February 2024.
3US Department of Agriculture, ‘Food Prices and Spending’, (ers.usda.gov), February 2024.
4The Washington Post, ‘Inflation has fallen. Why are groceries still so expensive?’, (washingtonpost.com), February 2024.
5Ipsos, ‘Registered voters are feeling pessimistic about the state of the US economy’, (Ipsos.com), November 2023.
6US Department of Agriculture, ‘Food Prices and Spending’, (ers.usda.gov), February 2024.
7Zillow, ‘Pandemic to Present: The Evolution of Rental Prices and Affordability’, (Zillow.com), February 2024.
8Federal Reserve Bank of St Louis, ‘What are long and variable lags in monetary policy?’, (stlouisfed.org), October 2023.
9Reuters, ‘US labor market cooling’ (reuters.com), March 2024.
10Philadelphia Federal Reserve Bank, ‘Large Bank Credit Card and Mortgage Data’, (philadelphiafed.org), January 2024.
11Trading Economics, ‘U.S. Retail Sales’, (tradingeconomics.com), February 2024.
12Federal Reserve, ‘Industrial Production’, (federalreserve.gov), February 2024.
13Gallup, ‘Most Important Problem’,(news.gallup.com), January 2024.
14Sifma, ‘Capital Markets Fact Book, 2023’, (sifma.org), July 2023, latest data available.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.
