The opportunity to lock in yields at current levels looks compelling, even if bond volatility is likely to remain elevated.
Bond yields have been on a rollercoaster ride over the past few years. The US 10-year yield even breached 5% for the first time since 2007. As we look to 2024, we feel more confident that both short and long-term interest rates have peaked and that investors should take the opportunity to lock in yields on high-quality fixed income.
Bond vigilantes
Why did bond yields spike? One explanation is that there is a supply and demand mismatch in government bond markets, particularly for US Treasuries. With a considerable amount of US government spending already legislated for, the concern is that issuance of government debt is overwhelming bond demand now that the Federal Reserve is no longer buying Treasuries.
At face value, this demand-supply mismatch has merit. Central banks absorbed a lot of the government debt issued in recent years and now seem firmly committed to reducing their balance sheets. It is also true that in the absence of quantitative easing the bond market is ‘free’ to tell governments when it perceives spending programmes to be too much. In other words, the bond vigilantes are back, as former UK Prime Minister Liz Truss learned only too well.
However, if private investors were worried about the uncontrollable profligacy of government spending, one might have expected the rise in yields to have been driven at least in part by higher inflation expectations. Instead, the move through the second half of 2023 has been almost entirely driven by real yields.
The explanation for higher bond yields that we find more compelling is that the US economy has simply proved more resilient to higher interest rates than was previously expected. Thus, the market has had to re-evaluate perceptions of what the sustainable or ‘neutral’ interest rate is. The neutral rate is sometimes referred to by economists as R-star. It is the interest rate that would prevail when the economy is at full employment and inflation is stable such that monetary policy is neither expansionary nor contractionary.
R-star gazing
Whether bond yields rise further depends on what we learn about R-star in the coming months. If economies remain resilient, and/or inflation is not showing signs of returning to 2%, then the rate cuts that are currently priced in will have to be removed – or even further hikes will need to be priced – which could put upward pressure on yields.
If, however, the economy shows signs of cracking under current policy rates as per our base case, then attention will turn to when and how much the central banks will cut. Relative to pricing in the middle of November, we expect central banks to cut later but by a greater amount. This would send bond yields lower and potentially release a sizeable capital gain – a 200bp decline in the US 10-year Treasury yield over the next 12 months would result in a total return of 21%.
In short, core bonds offer not only attractive income levels for investors but also potential capital gains in a recessionary scenario. The opportunity to lock in yields at current levels looks compelling, even if bond volatility is likely to remain elevated for some time.
Being selective with fixed income
An element of selectivity will still be required. In Europe, we see the risk that some governments in the periphery will not be able to resist the temptation of expansionary fiscal policy in 2024. The 10-year bond yield spread between Italy and Germany is below 200bps. As a result, we think higher quality core European sovereigns look more attractive than their peripheral counterparts.
Globally, investors will also probably favour sovereign bond markets where monetary policy prospects are the most favourable. While in the US and Europe, we – like many other investors – believe that policy rates have peaked, this is not the case in Japan. With the Bank of Japan set to normalise policy further in 2024, upward pressure on long-term Japanese bond yields looks set to remain.
Refinancing needs warrants a step up in quality
In corporate bond markets, both investment grade and high yield bond spreads have held in well this year thanks to a combination of relatively resilient growth and relatively little refinancing. The wall of refinancing to much higher interest rates is, however, coming. At face value it looks like 2024 maturities should be perfectly manageable, but corporates tend to look a year ahead when assessing capital needs, making the step up in maturities in 2025 a problem that will need to be addressed in 2024.
The situation is likely to be more problematic in high yield than it is in investment grade. While imminent maturities in high yield markets are not as large as investment grade counterparts, the gap between the current coupon and index yield is wider, suggesting a bigger jump in interest costs when corporates have to issue debt at higher rates.
This outlook leaves us with a preference for investment grade over high yield, where total returns could also benefit from higher rate sensitivity if government bond yields start to fall.
Emerging market debt
Local currency emerging market debt was a standout performer in 2023, given an environment of rapidly falling inflation and stable domestic currencies. High real rates and a shift to more dovish central bank policy – particularly in Latin America and Eastern Europe – provided plenty of tailwinds for these local markets. Going forward, the outlook is less straight forward. Geopolitical concerns raise the risk of a stronger US dollar, although further room for central bank easing should still provide a duration tailwind for local bonds.
Tight US credit conditions are currently a headwind for hard currency emerging market debt, but possible monetary easing from the US Federal Reserve and a subsequent easing of credit conditions could improve the outlook for the sector in the second half of 2024. Finally, in an environment where we generally aim to focus on higher quality assets, it is worth noting that emerging market fundamentals continue to improve as reflected by the growing share of A and AA rated countries in the universe.