30 Jan 2024
Author | Craig Macdonald Global Head of Fixed Income
Investors focused on when central banks will cut interest rates.
High-quality bonds will do well in our ‘most likely’ scenario.
Opportunity in bank debt but risks lie in smaller lenders.
Some areas of leveraged loans and private credit to cause problems.
Strong EMD performance will need to be supported by good country selection.
There were great expectations for bonds at the beginning of this year given the high yields on offer following the rapid rise in interest rates triggered by central banks in 2022 (see Chart 1). While many areas of fixed income have not disappointed in terms of generating strong total returns –the coupons paid plus capital gains – it has been the higher-risk parts of this asset class, rather than more traditional safer bonds, that have benefitted most.
What happened? Two things surprised investors this year: a stronger-than-expected global economy which, in turn, led to higher-than-expected inflation.
This meant central banks raised interest rates further than expected and any cuts – the market-boosting move investors had hoped for – have been delayed.
Chart 1: Composite investment grade, high yield, emerging market bond yields post 2010
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Source: Bloomberg, BaML indices, October 2023. For illustrative purposes only. No assumptions regarding future performance should be made.
The yields investors can get are still high – always a good starting point. Meanwhile, inflation is finally coming down which means interest rates in large economies such as the US, Europe and UK have likely peaked.
However, to turbocharge bond returns, central banks will need to start cutting interest rates by the second half of next year.
If we look at the historical relationship between interest-rate cutting cycles by the US Federal Reserve (Fed) and bond performance, the periods following peak interest rates have led to strong returns in many parts of fixed income (see Chart 2).
Chart 2: Investment-grade corporate bond total returns over past 4 Fed cycles.
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Source: Bloomberg, BaML indices, June 2023. For illustrative purposes only. No assumptions regarding future performance should be made.
Higher debt-servicing costs, shrinking central bank balance sheets and tight lending conditions are having an impact, amid rising defaults for smaller companies.
But this has been more than offset by the excess savings people built up during Covid lockdowns and a strong job market which has supported a stronger-than-expected global economy.
However, these excess savings will have mostly gone by the end of 2023 in countries like the US, and we are already seeing increasing auto loan and credit card defaults due to higher borrowing costs. This suggests consumer strength will diminish quite quickly next year.
Taken together, we should see an environment in which inflation falls further, the job market weakens slightly and the economy slows to a recession, or at least something that feels like a recession for many companies and countries.
When central bankers see that economies have slowed enough to bring inflation back to their target levels, they will cut interest rates – a move that will support many areas of the bond market.
We’re very optimistic about 2024 but here are six things that we’ll be paying particular attention to:
Higher quality bonds (i.e., government and investment grade). In our base case, or ‘most likely’, scenario these investments will perform particularly well as growth slows, inflation weakens, and central banks cut interest rates.
The risks: unexpected economic resilience and a resurgence in inflation would force central banks to raise interest rates again. This would be bad for most asset classes other than bonds with shorter tenors and money market funds.
Faster-than-expected excess savings depletion. Government bonds would do well in the less likely scenario in which the market has overestimated consumer strength – leading to a worse-than-expected recession.
The risks: bonds issued by most companies and banks would suffer. That said, if investors are nimble, the best time to invest in riskier bonds, such as high yield, is during the depths of a recession.
Banks. Despite some high-profile bank failures this year, we think most large banks have strong balance sheets and demonstrate good profitability. This will help cushion some increase in bad debts and tightening of lending standards. Bond yield spreads – the additional yield over comparable government bonds investors demand to compensate for extra risk – are still quite generous. This presents selective opportunities.
The risks: there are weaker lenders, most likely among the smaller and regional banks, that are overexposed to real estate borrowers. There’s more than US$2 trillion of real estate debt due for refinancing over the next 24 months, much of it on the balance sheets of US regional banks.
Downgrades and defaults. We’re less worried about investment-grade corporate bonds – high profit margins and conservative balance sheets have led to more upgrades than downgrades.
The risks: bond defaults linked to smaller and risker companies are rising. This will worsen in a slowing economy. That said, total returns from this high-yield debt should be greater than average returns during previous economic slowdowns/recessions, on better credit quality.
Leveraged loans and private credit. We see pockets of opportunity in higher-quality private credit which offer more generous yields to compensate for relative illiquidity. However, leveraged loans and private credit are parts of the debt market that have grown very quickly. This may be a problem because rapid growth often leads to weakening lending standards in the rush to put money to work.
The risks: defaults linked to leveraged loans have already exceeded those in the high-yield bond market, while the amount that creditors can recover is lower than historical averages. The riskier parts of private credit are also in focus. Again, problems will be clustered around smaller companies.
Emerging market debt (EMD). Good securities selection skills will unearth value among some of the higher-risk emerging market economies whose valuations are still cheap due to a difficult few years. Also, many emerging market countries will be among the first to cut interest rates, after being among the first to raise them. This should support local currency debt.
The risks: Investment grade valuations are at the tighter end so we’d need to see the US dollar weaken and yields on US Treasurys fall before investors will re-enter this market in numbers. The prospects also look less favourable should the dollar strengthen significantly or there’s a hard recession.
Fixed income valuations, and a different inflation profile to the past few years, should make 2024 a good year for bonds.
However, as with this year, it will not be all plain sailing. That’s why a dynamic approach and strong country and company selection will be needed to deliver on the promise.
The value of investments, and the income from them, can go down as well as up and an investor may get back less than the amount invested. Past performance is not a guide to future results.
Before investing, investors should consider carefully the investment objective, risks, charges, and expenses of a fund. This and other important information is contained in the prospectus and KIID document. The information is intended to be of general interest only and should not be considered as an offer, investment recommendation or solicitation, to deal in the shares of any securities or financial instruments.