A higher for longer interest rate environment would change the source of fixed income returns, rather than necessarily hurt them.

Our central expectation is that growth will be relatively resilient but inflation somewhat sticky, curtailing the ability of central banks to slash rates in the way that markets had hoped at the start of the year. While this has caused another bout of volatility in fixed income, we fundamentally believe that ‘higher for longer’ will prove good for fixed income investors.

Back to basics

Multi-asset investors have traditionally looked to fixed income for two things: a reliable income stream, and diversification in the case of growth shocks. In the decade prior to the pandemic, bonds largely lost their ability to do either as inflation, central bank policy rates and long-term government bond yields crept ever lower. Investors had to hope for even lower rates and measly capital gains to eke out any return in core bonds.

The shift from low inflation and low interest rates to what 20 years ago might have been perceived to be ‘normal’ rates has undoubtedly been painful. But now that we’re here, we think the prospects for fixed income investment returns are good.

In ‘normal’ interest rate times prior to the Global Financial Crisis, strong coupon payments formed a sizeable part of the returns investors enjoyed from their bonds. A higher-for-longer interest rate environment should change the source of fixed income returns, rather than necessarily hurt them. Falling yields would deliver attractive short-term capital returns, but these would be achieved at the cost of cannibalising future coupon payments.

For long-term investors, we believe core fixed income is compelling. While history is never a perfect guide to the future, from the current yield level, global aggregate bonds have historically delivered annualised returns in the region of 6.5% over the subsequent five years and have always delivered positive returns. This is because even in periods of rising yields, the higher starting point delivers a healthy cushion against any capital depreciation. For today’s investors, global aggregate bond yields would need to rise from 4% today to 7% over the next five years for investments to lose money over the same period.

Higher for longer due to resilient growth should support credit. It’s worth remembering that if policy rates remain relatively high, it will be because growth is proving resilient. If this is the case, then moderately riskier parts of fixed income such as high-quality corporate credit or peripheral European bonds will likely outperform their steadier counter parts.

Since 2000, the average default rate of US high yield in a year of increasing profits has been 1.6% compared to 4.6% in times of earnings contraction. Current default rates are 1.25%. If company earnings do not deteriorate substantially from here, we expect a continuation of the outperformance of credit versus government bonds, despite low spreads. However, in a higher-for-longer scenario, companies with relatively high and stable profitability and not overly extended balance sheets seem more attractive to us.

From a regional perspective, investors can take advantage of higher spreads in European high yield as the growth convergence (see Resilience in growth…and inflation) between the US and Europe should benefit the region.

Government bonds in the European periphery also look attractive as falling ECB interest rates have historically been a key pre-condition for periphery bonds in Europe to outperform. Spreads have remained tight this cycle, but justifiably so. The stronger growth outlook, the introduction of the European Central Bank’s Transmission Protection Instrument (TPI) and the EU Recovery Fund’s financial transfers should all be supportive for the fiscal stability of Italy and Spain, particularly relative to core Europe.

France’s debt has increased significantly in the last five years and the upcoming election is, in part, a test of whether the French population supports President Macron’s reforms that have sought to put France on a more sustainable path. Germany’s position as a role model of fiscal prudence is also undermined by the circumvention of the debt brake with special funding vehicles and by the non-consideration of EU liabilities. These factors have all contributed to a level reset in spreads and mean that spreads could remain sustainably tight despite higher overall yields, allowing the periphery to continue to outperform with potentially further tightening on the back of moderately falling rates.

While our base case is a rosy one for fixed income, we remain cognisant of the risks. Yield curves are inverted across the western world, and we would expect them to normalise primarily through short-dated yields falling as central banks gradually ease monetary policy. However, with so many cuts priced into rates markets, expansionary fiscal policy and sticky inflation have the potential to upset the long end of the curve.

In our view, the path to interest normalisation is not as broad or smooth as current low market volatility suggests and taking large duration risk doesn’t look attractive with the middle of the curve providing a better risk-return outlook for the next 6–12 months. While the absolute yield level favours US Treasuries over European sovereigns or UK Gilts, the greater possibility of a fiscal misstep in the US creates higher risks around our base case there. We do not expect European or UK bond markets to completely decouple from US yield movements, but our higher conviction in the path for central banks on this side of the Atlantic means we prefer European and UK duration on a relative basis.

After a painful two years, bond holders are understandably nervous about delays to the long-awaited central bank cuts. But even if the peak in rates is morphing into more of a plateau, we believe that the view from here is an attractive one for fixed income investors.

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