Seven things for fixed-income investors to bear in mind in these changing times
Until recently, the bond markets were dominated by inflation-related fears. This was reflected in falling bond prices, rising yields and widening spreads. But now, concerns about a potential recession are coming to the fore. Here are seven reasons why it may be worthwhile to hold on to your bond investments even in extremely challenging conditions.
Global economic growth is weakening in light of intense inflationary pressure. High prices, especially in the energy sector, are having a cooling effect on demand, which should ultimately reduce upward price pressure. This should help the central banks with their objective of safeguarding monetary stability. Nonetheless, the central banks are facing a dilemma and the bond markets have been feeling the adverse influence of the looming monetary policy shift since the start of the year.
Performance severely impacted by tightening monetary policy
Performance of different bond segments in the year to date*
The major central banks are resolved to press ahead with their cycle of interest-rate increases. They need to avert an inflation-driven wage-price spiral, take the heat out of inflation expectations (especially as geopolitical factors are causing price rises to become increasingly detached from market conditions), and prevent inflation from becoming entrenched. However, interest-rate adjustments have little influence on the prices of scarce commodities, for example in the gas market, and raising interest rates too sharply risks choking off economic growth. In this environment, the following seven insights may be of value to investors in the bond markets:
- Inflation requires patience: Persistently high inflation is a key driver of the downward trend in government bond prices. The question is whether inflation has now reached its peak. The picture is not very clear in this respect because the current price shock, especially in the energy market, is distorting the view. For now, it remains highly uncertain whether and when these effects may dissipate. However, there are signs that inflationary pressure may ease at least in the industrial sector. In the US, producer prices have started to fall slightly, albeit from an extremely high level. The distribution of demand across goods and services is becoming more evenly balanced, which should help to bring prices down. In addition, tensions in global supply chains are beginning to be resolved. Union Investment’s economists therefore predict that inflation will plateau for a time and then gradually diminish in the coming year. However, when it comes to energy prices in Europe (especially in the electricity and gas markets), there is still scope for unwelcome surprises. Moreover, inflation is also putting a damper on returns on investment. Investors will need some staying power because high inflation has driven real rates of return into negative territory. Looking ahead, this should change as inflation settles down. The current picture is heavily influenced by volatile components such as energy and food prices. When looking at core rates of inflation, the situation does not look quite as gloomy. The gap between core inflation rates and bond yields should start to narrow, but this will take time.
- Interest-rate policy is subject to uncertainty: Have interest-rate expectations already reached their peak? The fact that implied interest-rate expectations for the US and the eurozone – based on the latest economic data – have started to fall, seems to suggest so. ‘Safe havens’ recently benefited from fears of recession. Yields on both ten-year US Treasuries and ten-year Bunds fell significantly. But it is too early to say that we have reached a turning point. There is still considerable uncertainty about the future trajectory of inflation – especially in the eurozone, where big question marks loom over the security of gas supply from Russia. If the gas tap remains open, it may well be possible to avert a recession – depending on the volume and regularity of Russian deliveries. But if Russia abruptly cuts off the supply, Germany is likely to slip into a recession. At present, it seems reasonable to expect that the ECB will continue to normalise monetary policy even if the economy dips into a mild recession. This would put additional pressure on bond prices. The market is still pricing in sizeable interest-rate hikes. In the event of a recession, these may thus be priced out again, which should support the prices of safe-haven assets.
- Focus on volatility and liquidity: Given the current high levels of geopolitical uncertainty in the bond market, it does not seem advisable right now to commit to any exposure that relies heavily on interest rates moving in one specific direction. As market volatility remains extremely high, it pays to be cautious when it comes to strategic positioning. We expect that the focus of market participants’ concerns will continue to flip-flop between inflation and economic growth for some time. This also means that certain market segments will experience intermittent periods of lower liquidity. Focusing on high credit quality, broad diversification and strong market networks can be beneficial in these phases.
- Consider government bonds as a multi-asset portfolio component: The question that is currently at the forefront of fixed-income investors’ mind is what the ‘terminal rate’ will be, i.e. the base rate level at which the central banks will conclude their cycle of rate hikes. We expect that the European Central Bank (ECB) will continue to tighten monetary policy unless Russia turns off its gas supply to Europe and thereby triggers a recession. In the latter scenario, the normalisation of monetary policy, which has only just begun, would probably be pursued with a higher degree of caution. Union Investment’s economists predict that interest rates in the US will reach a target range of 3.25 per cent to 3.5 per cent by the end of the year and that the Federal Reserve will not raise rates any further next year. Assuming that Europe does not suffer a gas shock, the ECB is expected to raise the its deposit interest rate to 1.25 per cent by the end of 2022 and implement further rate hikes of 75 basis points in total in 2023. If the focus of concerns in the capital market shifts from inflation to the risk of a recession, the bond market should offer interesting investment opportunities again, especially in safe-haven segments such as high-quality government bonds. In a challenging economic environment, government bonds should also regain their ability to act as an effective means of diversification. At the start of the year, the onset of the interest-rate policy turnaround caused a break in correlation, meaning that both equities and bonds came under pressure at the same time. We believe that this situation will not persist as macroeconomic conditions change and that bonds may once again become a stabilising component in a multi-asset portfolio.
- No need to worry about a sovereign debt crisis in the eurozone: In the government bond segment, we currently prefer US Treasuries because they offer higher yields and are subject to lower geopolitical risk. A longer duration is also a bonus in this case. In the eurozone, bonds from core countries are likely to offer more stability than paper from the periphery. However, we do not anticipate a repeat of the eurozone sovereign bond crisis, when spreads on periphery bonds sky-rocketed. This assessment is primarily based on the fact that the debt ratios of many countries should start to fall again in the coming years, and at a swifter rate than previously expected. That is because the nominal trend growth rate of the economy has risen more sharply than average interest on government debt, due to higher inflation. However, it is important to keep an eye on political risks that could upset governments’ budget consolidation plans.
- Separate the wheat from the chaff in the corporate bond segment: In a scenario where economic growth slows down significantly or the economy falls into a recession, individual sub-segments of the corporate bond market will respond differently. The outlook for paper from investment-grade issuers would be better than that for bonds at the lower end of the BBB rating band or high-yield paper. And in a recession, cyclical paper and German bank bonds would be more at risk than defensive bonds. We have already seen the beginnings of these trends in recent months as spreads on cyclical bonds and on paper from lower-quality issuers have widened. Investment-grade corporate bonds are also suffering the negative impact of the ECB having terminated its asset purchases in the market. But its superior ratings performance is keeping the investment-grade segment supported. The risks associated with an economic slowdown have now been priced in to a large extent for bonds from issuers with weaker credit ratings. Nonetheless, investment-grade paper seems more likely to fare better in the near term given the threat of a potential recession. Once the outlook becomes clearer, high-yield bonds will probably regain their edge. These bonds are one of the few fixed-income asset classes that might generate a positive real rate of return against the backdrop of medium-term inflation expectations. However, this is subject to the proviso that the economy does not slip into a severe recession. But a cool-down of inflation expectations is supporting the market.
- Add assets from the emerging markets for diversification: Bonds from the emerging markets (EM) are an asset class that international investors rarely venture into at the moment. As a result, valuations have fallen and technical indicators have improved.
Bonds from the emerging markets are offering high yields again
Yields of bonds from the emerging markets have risen sharply
As at 20 July 2022.