I wasn’t totally wrong about 2023 being the year of the bond
The macroeconomic outlook suggests lower interest rates in 2024. Markets may have got ahead of the game in terms of the extent to which rate cuts are priced in, but as growth is expected to slow and inflation ease, the risk of further rate increases has diminished. Returns to credit investors should be supported by this. Corporate bond yields are still at a similar level to a year ago, meaning investors can look to another year of potentially decent income returns, even if lower growth threatens to create some volatility in credit spreads.
Expectations of 2023 being the year of the bond have not been fully met. The performance of government bond markets has been disappointing given the failure of the market to fully incorporate several things. First, inflation has been transitionary for longer and remains above central banks’ target levels. Second, markets underestimated the peak of interest rates. Third, markets were also blindsided by the firm commitment of monetary policymakers to argue that policy needed to stay restrictive until inflation was back at target levels. These three things combined to deliver negative returns for most government bond indices in the second quarter (Q2) and Q3. The ICE/Bank of America Global Government Bond Index delivered total returns of -0.94% in Q2 and -2.9% in Q3.
Priced in cuts
However, it now looks as though government bonds will deliver a modest positive return for the year, following a robust Q4 performance. After misjudging the level rates would reach, the expectation now is for significant cuts in 2024. At the end of December 2022, forward markets were pricing in a Fed Funds Rate peak of 5.0%. The actual level is 5.5% today. For the European Central Bank (ECB), the expected peak was 3.5%. It is 4.0% today. Those same forward markets are now pricing accumulated cuts of almost 150 basis points in 2024 from the Federal Reserve and similar from the ECB. This is based on the consensus of weaker growth and lower inflation. There is no guarantee, of course, that 2024 expectations will be any more accurate than those priced in a year ago. But the shift in sentiment has been meaningful and central bankers have been marginally less inclined to lean against it. Hence the impressive performance of rates markets in the final three months of the year.
Real yields still elevated
Fixed income momentum is strong - driven by the enthusiasm the market is displaying for hopefully lower rates in 2024. Some commentators are arguing markets have gone too far and the bond rally cannot continue. Yet US and UK bond market yields are still higher than they were at the start of 2023, and inflation is set to fall further in the coming months. Real yields are still elevated by recent historical standards – with a 2.0% yield on 10-year inflation-linked bonds, versus a 2024 real GDP growth consensus forecast of 1.2%. Embedded expected returns from bonds are attractive.
Bonds doing what they’re meant to
The “year of the bond” moniker is most relevant to credit markets. Bond yields rose in 2022 and credit spreads widened, therefore providing corporate bond investors with attractive entry points. For those who took advantage, the total returns have been strong. Generically, US investment grade bonds have delivered almost 6%, European investment grade bonds are up 6.4% and global high yield is up 9.5%. The attribution of the total return shows that most of it came from income – delivering what bonds are supposed to. For US investment grade, 4%-plus of the near 6% total return came from income. For global high yield, the market delivered a 6% income-based return.
Still positive on corporate bonds
What can we expect now from corporate bonds? I am still positive. The yields on offer suggest prospective returns that are better than those realised over the last two to three years. Lower policy rates, even if they do not meet current market expectations, could generate capital gains across the yield curve. If underlying rates curves steepen – with short rates coming down more than longer yields – this is likely to take place under bullish market conditions, meaning yields lower across the curve. As such, and with limited risk of rates going up again any time soon, longer duration credit strategies are attractive.
Lower-rated at most risk
Credit strategies have outperformed government bonds. Current credit spread levels suggest that will be the case again in 2024 unless there is a sharp deterioration in credit conditions that leads to spread widening. That is a risk, given the expectation of weaker economic growth undermining revenues and generating a deterioration in credit metrics for some borrowers. Historically, lower equity prices (negative returns) have led to wider credit spreads (negative credit returns), so any combination of lower growth and earnings disappointment would push spreads wider. Lower-rated parts of the market are most at risk – i.e., those borrowers with more leverage and weaker balance sheets. Hence quite a consensus on the sell-side for decompression – that is, a widening of lower rated spreads. The coefficient of correlation between spreads and equity returns is the highest for high yield. However, even CCC-rated spreads have recently narrowed relative to BB-rated. That, together with credit default swap indices – which offer a potential buffer to investors - trading at their lowest levels of the year, suggests investors, in aggregate, are not overly concerned about credit issues. There are forecasts for higher default rates going forward, but yields are high enough for investors to think that they remain well compensated for that risk.
The beauty of bonds
Volatility in asset prices is given. For investors with more than a short-term investment horizon, the starting yield is important in determining expected returns. Historically, the near 6% yield on the Bloomberg US Corporate Bond Index suggests that, over three years, total returns are likely to be mostly between around 5%-9% (based on data going back 40 years).The longer the holding period, the closer total returns will be to the initial yield. That is the beauty of bonds. High yield is attractive for higher income and some pseudo-equity exposure if one is not totally convinced about equity exposure at this point in the cycle.
Exposure to emerging markets
The other area of credit which has performed well is emerging market debt. Again, income has been important, representing 5.4% of the 7.8% total return on the JP Morgan EMBI Global Diversified Index, year-to-date. Lower dollar rates have helped and should help again next year, while lower inflation should help many emerging economies loosen domestic monetary policy. Having some emerging market bond exposure does provide some diversification to a credit portfolio.
Part of the reason for the positive view on credit is that this cycle has not seen a huge build-up in speculative borrowing. The face value of the US high yield market has declined since 2021 by around 15%. The face value of the US investment grade market has risen by 5% this year (proxied by the ICE/BofA US Corporate Bond Index), while nominal GDP is likely to have risen some 6.55%-7.0%. Company balance sheets still benefit from having been able to term out debt and lock in low interest rates during 2020-2021. Fundamentals may deteriorate going forward, but they are in decent shape today. Given where yields are relative to the recent historical cost of borrowing (yield-to-maturity of 5% on the global credit market compared to an average weighted coupon of 3.5%), companies will be cautious about borrowing. If the general view is that yields are going down, it makes sense to wait unless there is an urgent need to refinance debt. At the same time, demand remains strong and the additional income on offer from corporate bonds relative to rates should continue to support that. The technical set-up is positive.
It has been the year of the corporate bond. Returns have been better than the 10-year average for most credit sectors. Corporate bonds have outperformed government bonds and, in some cases – for example the UK market – corporate bonds have done better than equities. With rates stabilising and returns from government bonds also set to improve, 2024 should, in my view, also be a decent year for fixed income investors.
(Performance data/data sources: Refinitiv Datastream, Bloomberg, as of 7 December 2023). Past performance should not be seen as a guide to future returns.