Investment Outlook: Bond Strategies for the Summer
Before setting the out of office, it would be worth considering how to position portfolios for the summer months and beyond. Importantly, fixed income investors must face the challenges of potentially more hawkish monetary policy and inflation uncertainty. In our Q3 Bond Compass, we look at three approaches to the current environment: emerging market debt, investment grade credit, and a barbell approach using short and long exposures for yield pick-up and protection.
Q3 2023
Emerging Markets Dance to a Different Tune
- There are reasons why the strong returns in H1 from emerging market (EM) local currency debt could continue. We see a strong coupon dynamic, EM central banks edging closer to easing policy, and the USD still looking overvalued. EM debt’s lower correlations to Treasuries provide the additional benefit of better portfolio diversification.
It has been a strong start to the year for EM debt, with the Bloomberg EM Local Currency Liquid Index returning more than 6% in H1. This rise compares favourably to treasuries (+1.6%) and US investment grade credit (+3.2%). As we indicated in our note, Emerging Markets and How to Play Them, there have been previous periods when EM debt enjoyed high returns for sustained periods of time. The USD still looks around 10% expensive versus EM currencies1, meaning tailwinds from an ongoing, gradual USD depreciation coupled with high coupon yields should continue to support returns in H2 2023. The bigger question revolves around when EM central banks will start to ease policy.
Divergence
The maturity of the EM hiking cycle and the fact that inflation pressures are now easing certainly creates the backdrop for easier policy. Moreover, the heavy inversion at the front end of many of the EM bond curves suggests that the market believes cuts are on the way. China has moved to ease policy already, but its economic trajectory has been a little different from most of the rest of the EM world. Hints from the Brazilian central bank of a late summer cut are potentially more indicative that the policy cycle is turning. The final piece of the puzzle could be the Fed. A little more than one rate rise is priced by the market and signals that this is the top to US rates should give EM central banks the confidence that they can cut rates and not see their currencies depreciate.
Policy divergence between emerging and developed markets also offers an additional bonus in the form of diversification. Correlations were high in 2022 with almost all assets declining in value. EM also suffered significant fall-out from the invasion of Ukraine. However, 2023 has seen the correlation of EM bonds to both Treasuries and US investment grade credit fall materially, which can help with portfolio diversification.
Risks Look Country-Specific
There are always idiosyncratic risks within EM – witness the negative returns of Turkey (-33%) that, while a relatively small part of the index (1.3%), have weighed on performance. With a new economic team in place at the Turkish central bank, there are hopes that the worst is now behind us and that this should be less of a drag on performance in Q3. However, there is a broader potential threat to EM from a US recession. State Street Global Advisors does not expect a recession to materialise until 2024 (see the Midyear 2023 Global Market Outlook) and, as noted above, EM central banks are in a far better position to cut rates in order to offset the impact of slower global growth. On aggregate, central bank rates are high from a historical perspective (Figure 2), meaning they can be cut by some margin and still be left at levels that can be viewed as fairly normal.
The market sees limited risks from either high current central bank rates or from a global slowdown on credit worthiness of EM nations. The average weighted 5-year CDS spread for the countries that make up the Bloomberg EM Local Currency Liquid Government Bond Index has fallen materially from its peak in October 2022.
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Investment Grade Credit – Yield Provides Some Protection
- Investment grade credit should remain a key building block for investor portfolios. It offers a yield pick-up versus government bonds, which may ensure more stable returns. Added protection could come from an ESG strategy, where we have typically seen better performance in volatile environments.
The first half of 2023 did not prove quite as lucrative for investors in investment grade (IG) exposures as many had been hoped at the start of the year. Still-resilient growth and the reluctance of inflation to rapidly retrace to lower levels has pushed up expectations for central bank policy rates and this has weighed on bonds. For US IG, the additional yield on credit coupled with a spread tightening to government bonds has allowed credit to outperform Treasury exposures with returns during H1 more than 160 bps above those from a Treasury only exposure2. In Europe, returns have been slightly lower for IG than government all-curve exposure, but this has been due to the considerably longer duration of the government index. Credit spreads have compressed, suggesting better performance from IG on a like-for-like basis.
Q3 could see the backdrop remain similar – inflation is falling, but only gradually. Growth is holding up well, especially in the US where, for instance, the Citi US Economic Surprise index has been in positive territory almost continually since early February3. This should continue to favour investors in IG exposures with the higher yields on offer, relative to government exposures, underpinning returns.
Indeed, the combination of rising yields and falling index durations leaves IG exposures looking significantly more defensive. Dividing the index yield by its duration gives a rough breakeven level for how much yields need to increase in order to negate the index yield. These breakevens have risen to what are historically high levels (Figure 1), highlighting the current defensiveness of credit. For euro exposures, market yields would need to increase by close to 100 bps to offset the positive gains from the index yield.
The risks to credit stem from a sharp economic slowdown or even a recession. The euro area is already in a technical recession and State Street Global Advisors expects the US recession to arrive in 2024 (see the Midyear 2023 Global Market Outlook). However, a material impact on the credit quality of issuers has yet to arrive, with the upgrades versus downgrades ratio still strong in North America and in Western Europe in particular.4
ESG is Back in the Game
After a tricky 2022, given the focus on energy, 2023 has seen an improvement in flows into ESG-based strategies. From a fundamental perspective, areas such as energy security, which could push more investment into renewables, and the excitement around the potential of AI has supported technology, an area that ESG exposures are often overweight in.
There is also some evidence that ESG screens have benefitted investors in times of volatility. Figure 2 shows the monthly excess returns of the Bloomberg SASB US Corporate ESG Ex-Controversies Select Index less those from the Bloomberg US Corporate Total Return Index. This should give an indication of the degree to which the selection of the bonds within the Bloomberg SASB index are adding to, or detracting from, performance relative to the standard market-weighted index.
There have been several instances where the excess returns from the Bloomberg SASB US Corporate ESG Ex-Controversies Select Index have clearly outstripped those of the market-weighted Bloomberg US Corporate Total Return Index. The most notable period was during the COVID crisis but there are also signs of outperformance in February/March 2022, when Ukraine was invaded, and then later in October 2022 as the bond sell-off reached its peak. Since the inception of the index (30 September 2019), it has delivered excess returns of 105 bps, or around 27 bps per annum, over the standard market-weighted index5.
The generation of excess returns is slightly lower from the Bloomberg SASB Euro Corporate ESG Ex-Controversies Select Index (around 8 bps per annum) but, with the geopolitical backdrop expected to remain volatile for the foreseeable future, there may be some advantages to taking an ESG-screened approach to investing.
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Barbelling Risk
- Expectations of more aggressive policy actions from central banks have inverted market curves. This has left the middle of the curve looking stretched and provides an opportunity to allocate into short and long exposures to pick up yield.
The fixed income markets continue to fixate on the scenario where central banks are forced into an abrupt policy turn as growth slows. Coming into 2023, Federal Reserve rates were priced to hit 4.9% mid-year, following which expectations were that they would be cut to around 4.25% by year end. This has not materialized, with the fed funds rate in the 5.00-5.25% range and the market still priced for at least one further hike. The obsession with cuts continues, with the one-year forward of the one-month rate down at 4.5%.
This conviction that the turn in rates is just over the horizon has pushed the curve flatter and the resulting inversion of the 2s10s spread has left the belly of the curve looking relatively expensive. Figure 1 shows the spread for USD, EUR and GBP of the yield on the all-curve exposure minus that of the short and long indices6. The wings of the curve look relatively cheap, with the barbell at its lowest level in 10 years for EUR and GBP. All three curves have a negative spread, implying that a pick-up in yield can be obtained by moving out of the all-curve exposure and into the short and long buckets.
Short End for Yield, Long End for Duration and Convexity
Constructing a portfolio using short and long maturity buckets has its advantages. The inversion of the curve between 2 and 10 years of 75 bps for Germany, 85 bps for the UK and 105 bps7 in the US means that a heavier weight in short maturities provides a significant uplift to yield.
Conversely, the curve beyond 10 years is relatively flat, meaning there is little give-up of yield from moving longer. This also means that there is no compensation for taking on duration risk. However, with inflation coming down (and now below the fed funds rate) and policy tightening still feeding through, central bank rates do look close to their peak. In this context, some duration risk is desirable although maybe less so in the UK where there remains a considerable amount of tightening priced.
Figure 2: Combining Short and Long Exposures and How that Compares to the Whole Curve
| US Treasuries | Euro Govt | UK Govt | ||||||
|---|---|---|---|---|---|---|---|---|
| Yield | Duration | Convexity | Yield | Duration | Convexity | Yield | Duration | |
| Short | 4.96 | 1.8 | 0.05 | 3.39 | 1.93 | 0.05 | 5.23 | 2.68 |
| All Curve | 4.37 | 6.12 | 0.83 | 3.21 | 7.28 | 1.03 | 4.71 | 9.59 |
| Long | 3.97 | 15.97 | 3.32 | 3.3 | 14.69 | 2.98 | 4.44 | 17.21 |
| Short+Long | 4.47 | 8.88 | 1.68 | 3.34 | 8.31 | 1.52 | 4.84 | 9.95 |
| Difference | 0.09 | 2.76 | 0.85 | 0.13 | 1.03 | 0.48 | 0.12 | 0.35 |
Source: State Street Global Advisors, Bloomberg Finance L.P., as of 30 June 2023. Short + long bucket is 50/50 weighted. The data in the table above are as of the date indicated, are subject to change, and should not be relied upon as current thereafter.
Figure 2 shows the key characteristics of short, all-curve and long indices with the short + long barbell being a 50/50 combination of the short and long exposures. For all three curves, combining the short and long exposures results in a higher yield to worst than if the all-curve exposure were held. The trade-off is a longer duration profile, in the case of US Treasuries one that is 2.7 years longer. This also comes with an uplift to convexity above levels seen in the all-curve exposure. If we are close to the turn in policy rates then, in addition to a higher yield, the additional duration and convexity could produce higher returns from the barbell strategy than from the all-curve exposure. The additional convexity is of particular value, implying the duration of the barbell strategy will increase faster than the all-curve exposure if yields do decline.
Figure 3: Index Total Returns for Q2
| Returns (%) | Treasury | Euro Govt | UK Govt |
|---|---|---|---|
| Short | -0.6 | -0.24 | -3.02 |
| All Curve | -1.38 | 0.05 | -5.95 |
| Long | -2.3 | 0.72 | -8.32 |
| Short + Long | -1.45 | 0.24 | -5.67 |
| Difference | -0.07 | 0.19 | 0.28 |
Source: Bloomberg Finance L.P., as of 30 June 2023. Short + long bucket is 50/50 weighted. Past performance is not a reliable indicator of future performance. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment.
Perhaps the broader concern for investors is that the economic backdrop seen in Q2 persists. However, the fact that the curve has tended to invert when yields move higher means the long end has been less impacted. Figure 3 shows the Q2 total returns for the short, all-curve and long-maturity indices and then what that implies for the barbell. Even for the Treasury market, where the duration of the combined strategy is significantly longer, it underperformed the all-maturity index by just 7 bps during the quarter. The Euro and UK barbells both outperformed despite some heavily negative returns in the UK as the market moved to price in a significantly more aggressive rate profile for the Bank of England.
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