Ten pressing questions for fixed-income investors

An article by Christian Kopf,
Head of Fixed-Income Portfolio Management and a member of the Union Investment Committee (UIC)

Thankfully, inflation in the US seems to be past its peak now. That applies to both overall inflation and core inflation. In the eurozone, we are probably at the peak right now, although uncertainty remains high. Inflation is the decisive factor when it comes to whether or not the high levels of interest-rate volatility that we have been seeing in the market will disappear, keeping credit spreads contained. It will also determine the level at which the central banks eventually conclude their cycle of interest-rate increases. The slowdown in economic growth (we anticipate a mild recession in the US and in the eurozone over the winter months), the damping effects of tightening monetary policy worldwide and the fact that prices for base products and intermediates have fallen again thanks to more stable supply chains all suggest that inflation will come down.

If inflation rates fall as we expect them to, the pressure on central banks to act will ease, which will allow them to rein in or stop the tightening of monetary policy. Exactly when this might happen still remains unclear. The central banks will be keen not to repeat the mistakes of the 1970s, when – for example – the US Federal Reserve (Fed) stopped tightening monetary policy too soon because it wanted to stimulate growth. We believe that the Fed is close to the end of its cycle and predict the Fed funds rate in 2023 at 4.5–4.75 per cent. 
 However, we disagree with the market in that we do not foresee any interest-rate cuts for 2023. In the eurozone, meanwhile, we expect the deposit interest rate of the European Central Bank (ECB) to climb to 3.25 per cent in 2023. In the spring, the ECB will then shift its attention to trimming down its balance sheet (quantitative tightening). Looking at the government bond market, we anticipate rather a sideways trend for US Treasury yields but a continued upward trend in Bund yields.

Quantitative tightening will probably create additional upward pressure on yields. If the ECB starts to scale back its balance sheet in spring, as we currently expect, asset classes that have been at the heart of its purchase programmes will be most affected. Eurozone periphery bonds, and above all Italian paper, are prime examples. Italy is going to have huge refinancing needs. We therefore believe that spreads in this segment will widen substantially in the first quarter. The impact on covered bonds, supranational institutions (SSAs) and corporate bonds will probably be limited. In the US, the Fed is taking a rules-based approach to quantitative tightening. Using ‘passive’ measures to trim down the balance sheet allows market participants to plan ahead and helps to minimise the impact of the process on the market. As the take-up of government bonds by the Fed starts to diminish, other market participants might demand higher yields on the remaining paper. This would cause both yields and maturity premiums on US treasuries to rise. However, this is not a trend we are currently seeing. The yield curve is strongly inverted and there is no maturity premium in sight.

The US is currently recording the strongest level of inversion in around 40 years, with yields on two-year US Treasuries around 82 basis points above those of ten-year paper. The German yield curve has also started to become inverted, albeit only slightly. As inflation seems to be peaking sooner in the US than in the eurozone, upward pressure on US Treasury yields is generally likely to be much lower than that on government bonds from core eurozone countries. The inverted yield curves can also be seen as an accurate reflection of the challenging economic conditions of the winter recession in the US and the eurozone. However, they should not be interpreted as a harbinger of a severe economic downturn. Recent macroeconomic data indicates that economic activity is starting to stabilise at a lower level. The Fed’s quantitative tightening measures could also have an impact on maturity premiums going forward, although we regard it as very unlikely that premiums will return to levels seen in pre-quantitative easing times.

There is also an upside to higher volatility in the capital markets: Yields in the bond markets will go up again, especially those on investment-grade corporate bonds and government paper. This means that investors will no longer be forced to climb so high up the risk ladder in order to achieve a decent return. However, it is important for investors to understand which side is driving the market volatility. If equity volatility is dominant, the equity-bond correlation works well, i.e. bonds are able to mitigate falling share prices to an extent. But if conditions are shaped by interest-rate volatility, the equity-bond correlation no longer applies. In these instances, bonds do little to help stabilise mixed portfolios. Inflation-linked bonds can be added to the portfolio in order to gain some protection against the risk of sharply rising inflation. And ensuring that the fixed-income asset allocation is broadly diversified across international markets is advisable for optimised returns.

At present, our research is not detecting an increase in market stress. On the contrary, relevant indicators have recently been trending downwards again. That is, of course, no reason to throw caution to the wind. But it does mean that we no longer need to position ourselves extremely defensively. The recent recovery should not lead us to believe that things can only go one way, because the market remains volatile. However, we do not expect asset swap spreads on corporate bonds to climb above 125 basis points again. The strong correlation between interest rates and spreads will probably persist. In our view, fundamental economic risks are currently priced in to a reasonable extent in many market segments. For corporate bonds, it will be important that the winter recession does not become too severe. But there are risk factors – in Italy, for example – that investors should keep an eye on. And spreads on riskier assets such as high-yield bonds could widen again. If the recession turns out to be deeper than expected, fundamental factors will become more relevant. Companies that are highly indebted, lack robustness in their business models or are strongly affected by the energy crisis (e.g. the chemicals and industrial sectors) are most at risk in this scenario.

The financial sector is benefiting from rising interest rates right now and will be boosted by higher net interest margins going forward. Real estate, which had been eschewed by investors in recent months due to the sharp upward trend in interest rates, could now bottom out, provided the economic slowdown does not turn into a severe recession. The focus will likely be on residential and logistics property rather than retail real estate. By contrast, cyclically sensitive sectors such as consumer discretionary (clothing, entertainment) and the automotive sector should be treated with caution.

We continue to favour investment-grade (IG) corporate bonds, which are still yielding around 3.7 per cent at present. This is because large businesses can absorb the effects of higher costs more easily. High inflation could even prove beneficial to them, because stronger nominal revenue growth typically leads to a stabilisation or even a slight fall in their debt ratio. However, careful selection will be key when it comes to minimising credit risk. The high-yield segment is currently offering the most attractive potential returns, but it is also particularly exposed to interest-rate risks and macroeconomic risks. On the other hand, structured credits – especially collateralised loan obligations (CLOs) – offer an attractive risk/return profile in an environment of elevated inflation and high volatility in the interest-rate markets. Variable interest rates protect CLOs against interest-rate risk, although this effect becomes less relevant if the pace of interest-rate changes slows down. At present, we are seeing hardly any defaults among IG products, but loan defaults are likely to become more prevalent in a recession. However, the overall market should be able to absorb this easily. If the downturn does turn out to be more severe, CLO spreads will probably widen more than those of other asset classes. This is why it pays to be careful in a recessionary environment. Active security selection and strict risk management are essential.

The emerging markets continue to be influenced very strongly by sentiment in the dominant US and eurozone bond markets. In light of the recent easing of inflationary pressure in the US, the emerging markets have strengthened a little. We are thus more optimistic now with regard to spreads and duration. Moreover, the pronounced divergence between trends in IG-rated countries and high-yield countries has started to disappear. Nonetheless, we remain vigilant and very mindful of how important it is to choose countries and issuers carefully. In China, we are seeing clear signs that Beijing is relaxing its coronavirus policy. On balance, local Chinese government bonds are being supported by the prospect of structurally lower economic growth in the country. However, we doubt that inflation in China will remain low as and when the Chinese economy reopens. At this point, China will probably experience inflationary catch-up effects similar to those seen in the West. Cyclical considerations support a relatively cautious positioning in the Chinese interest-rate market.

Many investors are currently using new issues in the primary market in order to rebuild their exposure to longer maturities. Until recently, the goal had been to reduce interest-rate sensitivity, whereas now, demand for longer-dated paper is picking up again. Investment-grade bonds with shorter to medium-term maturities remain our preference for now as their combination of decent yields and limited interest-rate risk offers a partial buffer against any further interest-rate rises and price falls. Likewise, we are favouring short-dated and medium-maturity paper in the government bond segment.

As at 16 December 2022.