Fixed Income asset class overview

15 min read 23 Feb 23

Month in review

After a very strong January, markets saw weaker performance across the board in February on the back of renewed concerns about the persistence of inflation.  While inflation numbers are generally coming down, sticky components such as wages and service prices remain elevated, and the CPI prints show that inflation is very broad based. Labour market data continue to look particularly strong. While the direction seems to be downward, inflationary pressures are not easing as much as the market initially thought. This has led investors to reprice their expectations of central bank interest rate hikes. 

On the back of this, bonds, equities and commodities generally saw weak performance during February. Sovereign bonds saw losses with the upward revision in inflation expectations. The month also brought a reversal of many of the January gains in currency markets.

Riskier assets including investment grade and high yield corporate bonds declined in February as the central banks turned more hawkish in light of the stronger-than- expected macroeconomic data. However, much of the sell-off in corporate bonds was driven by interest rates, with credit spreads having remained somewhat more resilient. Emerging market debt returns were broadly negative in February, driven both by higher US rates and the stronger US dollar.

Looking at the broader picture, the good news is that valuations are looking compelling for long-term investors at these levels, in our opinion. In particular, both the interest rate and credit components of corporate bonds are now elevated, providing investors with some in-built diversification, since these components tend to be inversely correlated.

Developed Market Sovereigns

It was a wild month for global bond markets, with losses for US Treasuries (-2.4%), bunds (-2.5%) and gilts (-3.3%), driven by some strong and revised inflation data for January combined with even stronger revised payrolls. In the US and in Europe, we saw upward revisions to much of the inflation data and some impactful revisions to payrolls data. In a nutshell, core inflation is rising across developed markets and there isn’t much sign of the labour market loosening on the back of what is now nine months of rate hikes.

Source: Bloomberg, 28 February 2023
Past performance is not a guide to future performance.

While it is common knowledge that monetary policy works with a lag, so far we are seeing very little impact, if at all. Markets have (rightly, in our opinion) repriced the terminal rate (the interest rate at which they expect the cycle of hikes to end) to around 5.4%. This means more hikes this year than were expected in January, while cuts at the end of 2023 are no longer being priced in. As a result developed market (DM) sovereigns saw a continuation of the front-end sell off, a continued flattening of the yield curve and a return of the hawkish narrative.

Front-end yields have repriced by a  huge amount over the last 12 months. We are perhaps only one data release away from a reversal of this trend, but in the meantime money market funds are paying around 5% for a six-month bill. The longer end of the curve is now very flat, and still appears to be pricing-in transitory inflation and a return close to target. This chart, showing the yields for two-year notes in major economies, says it all.

Source: Bloomberg, M&G 28 February 2023

Where will the terminal rate be?

The terminal rate is the rate at which central banks are expected to finally stop hiking rates. In the US that number has moved up significantly over the last year and now sits at 5.35%.

The Fed doesn’t know exactly where they should stop. They hike rates and then see how the economy responds. The data we have been receiving so far this year suggests there is still more work to do: growth estimates keep getting revised higher, inflation is not coming down as fast as the Fed was hoping and financial conditions have eased in recent months.

The Fed is data-dependent, and the economic data they have received so far this year won’t encourage them to stop hiking. We think there is a very good chance that the terminal rate will have to be revised higher, and it could end up being closer to 6% than to 5%.


While US CPI (6.4%) continues to show signs of slowing, it came in slightly ahead of expectations (6.2%). Moreover, the sticky part of the inflation basket (mainly services) remains extremely elevated, with core inflation coming in at 5.6%.

CPI numbers also remain elevated in the UK and Europe with continued energy price pressures. UK CPI fell very slightly but remains high at 10.1%, while eurozone CPI came in at 8.6%.

The key takeaway from recent inflation prints is that the rise in prices is very broad-based, highlighting that inflationary pressures are not easing as much as the market initially thought. While we remain in a disinflationary environment, there is still lots more work to do before central banks can finally claim victory over inflation.

Developed labour markets remain strong, driving further wage increases, meaning inflation may remain at elevated levels for some time. On the other hand, money supply is coming down, which should mean the overall trajectory is downwards.

Going forward we expect inflation to continue to trend lower driven by core goods, although core services will likely remain sticky, potentially putting a floor on where overall inflation will eventually settle.

Inflation-linked valuations

Inflation breakeven rates (the difference between the yield of inflation-linked bonds and nominal bonds of the same maturity) rose in February across the US, Europe and the UK on the back of higher-than-expected CPI figures and robust economic data.

We currently see good value in UK breakevens as we don’t believe inflation will come down as quickly as some are predicting. Wages are sticky and slow-moving and, in our view, the Bank of England is too dovish given the level of inflation we are seeing. The Bank faces a difficult job, in our view, having been behind the curve and with the UK economy being very sensitive to the housing market. Other factors which are likely to have an inflationary impact include a weak sterling and ongoing labour shortages post-Brexit. All of this makes us think that UK inflation could stay higher for longer.

For more thoughts on inflation see our recent blog on Bond Vigilantes

Investment grade credit

After a strong start of the year, investment grade markets declined in February as central banks turned more hawkish driven by solid macro-economic data. Rates were higher, while spreads closed the month generally flat. The volatility in corporate bonds was partially caused by heavy issuance.

USD IG corporate bonds generally underperformed and, in our view, now look cheap versus other markets. Across sectors, utilities underperformed, while European banks continue to outperform. Longer-duration IG was a significant underperformer in February, while BBB names underperformed higher-quality IG bonds.

The Global Investment Grade index traded with a spread of 135bp in February, marginally wider than in the previous month. Overall yields remain historically high. Currently the EUR IG index offers a yield of 4.4%, the GBP IG index has an yield of 5.7%, while the US market is at 5.6%.

Going forward

The global economy is rebounding and inflation is not decelerating as much as expected. We think this will pressure central banks to do more, moving terminal rates higher. In this environment, rates are likely to remain volatile for some time, although in our view spreads should be supported by the improving macro-economic outlook.

Unlike a year ago, however, the higher yield cushion provided by the IG market will likely smooth rates volatility and help avoid the sharp losses seen in 2022. Also, while the terminal rate is still unknown, we probably are near the end of this tightening cycle, meaning the potential downside coming from duration should be limited.

Spreads have tightened in recent months, highlighting the positive momentum for growth. However, the extra compensation investors receive from owning IG credit remains historically elevated, and in our view still provides a good entry point for patient investors. In the near term, supply could add some volatility to credit, with March expected to be busy in terms of primary activity. However, the overall supply this year should stay relatively limited, while demand for the asset class remains robust. This could create a strong technical factor for the IG market.

Source: Bloomberg, 28 February 2023
Past performance is not a guide to future performance.

High yield credit

After a very strong January for risk assets, February saw that go into reverse and HY markets fell -1.2%. This was mainly a rate story though, driven by growing concerns about inflation and expectations of further central bank hikes. HY spreads, however, remained resilient, seeing only very small widening despite rate volatility.

Spread returns were positive. HY spreads tightened by 8bp in the US and 24bp in Europe to close the month at 422bp and 435bp respectively. Euro HY spreads have been tightening relative to the US since October and the risk premia differential has now almost closed.

After a busy January, primary markets have slowed again in February. While the pace of this year’s issuance is higher than 2022, it is still lighter than historical levels. Relatively light supply and attractive all-in yields should be supportive for HY, in our opinion.

It is worth noting that the amount of distressed debt in US HY has trended lower recently, and remains consistent with a 3-5% default rate over the next 12/18 months. However, given the immediate pass-through of higher policy rates and limited free cashflow for some issuers, credit selection will be crucial. We continue to work with the analysts to ensure we are comfortable with interest coverage.

Source: Bloomberg, 28 February 2023
Past performance is not a guide to future performance.

Current market view
  • Generally neutral on valuations after recent spread tightening.
  • Technical elements (supply/demand imbalance, attractive all-in yields) expected to provide a tailwind.
  • Fundamentals generally supportive for now, although need to work closely with analysts to avoid issuer-specific blow-ups.
  • We expect a more shallow default cycle versus what is currently being priced in by markets
  • Generally concentrating on more defensive sectors and higher-quality issuers.
  • We are closing out our overweight in Europe following strong performance, to rebalance towards the US.

Emerging market bonds

Returns were broadly negative across the board in February, driven primarily by higher US Treasury yields and a stronger USD, putting an end to the EM bond rally we had witnessed in the last three months. Overall, the local currency government bond index declined by 3.2% in February, while hard currency government bonds and hard currency corporate bonds declined by 2.2% and 1.6% respectively. Hard currency corporate bonds proved more resilient due to their higher quality bias and lower duration versus hard currency government bonds.

In terms of spreads, movements were more resilient at the index level, with little contagion from higher rates in February. HY EM sovereign spreads underperformed at the margin, with spreads widening from 796 to 814 bps, while HY EM corporate spreads widened 9 bps. Corporate and government investment grade spreads ended the month slightly tighter at the index level.

Stickier and more persistent inflation data in developed markets has sent the recent positive performance trend into reverse. Despite this recent setback, we believe valuations remain historically attractive and are still pricing in a lot of macroeconomic uncertainties. This is especially the case in the HY segment of the market, with spreads and yields at levels still rarely reached outside of the GFC and the COVID crisis. In addition, the increase in USD rates we have seen over 2022 results in historically high overall yields, which should be conducive to attractive returns in the medium term and act as a buffer against further short-term volatility.

We have also started seeing inflation peak in a number of EM countries, as the effect of the early and aggressive hikes by central banks is being felt. There has been significant divergence in performance between different segments and regions within EM, providing opportunities for relative value trades. However, as risks have increased in particular for some of the weaker countries, thorough research and bottom-up analysis will be more important than ever going forward.

Source: Bloomberg, 28 February 2023
Past performance is not a guide to future performance.


In line with the general repricing of risk in February we saw a reversal of many of the January gains in currency markets. Those countries that export commodities priced in USD did better than the importers, as the Fed’s more aggressive stance saw a renewed flight towards the USD and a tightening of financial conditions in those regions.

While there is a still a worry the USD is super-expensive, even after the weakness of the last few months, it is worth noting that a downturn in market sentiment has typically been associated with USD strength.

Interest rate differentials (IRDs) do not appear hugely compelling right now - cheaper/weaker G4 and G10 currencies mean that in some cases sovereign debt yields more than USTs on a currency-hedged basis. This dynamic probably explains the recent flows into EUR and the uptick in European bond markets.

We are seeing exactly the reverse of this situation in Japan. Yen strength has meant that even with wide IRDs vs G4 currencies, the currency-hedged yields are lower than before. Yield Curve Control (YCC) hasn’t helped in this respect, by pinning Japanese 10-year yields at 50bps.  Even though core inflation is rising, bond markets are not allowed to react. On the other hand, if yields were allowed to rise, Japanese investors may favour their domestic debt over US, prompting a sell-off in US Treasuries. Given that the Japanese government are the largest foreign holder of USTs, they will be mindful on the effect of their own portfolio valuations.

On a monthly basis, the Mexican peso (MXN) has performed well. The MXN curves tend to follow the US and given recent increases at the front-end of the Treasury curve, higher short-dated yields appear to have increased demand for the currency. It is worth noting that the MXN has already moved a long way, so we are not as constructive on the currency as we were, although the curve is mature in nature, with plenty of local bonds of various maturities.

We expected to see further volatility in 2023, driven by changing inflation expectations, relative global growth metrics and of course, country-specific risks.

Source: Bloomberg, 28 February 2023
Past performance is not a guide to future performance.

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