Amid continued challenges to fixed income, one potential option is to look at broader strategies with more diversified risks. Global aggregate bonds have typically posted positive returns during periods of slower economic growth but could also prove less vulnerable to a sell-off if growth remains firm, as credit spreads should tighten. Having undergone some precipitous falls during the first half of 2022, there is certainly scope for a rebound.
The environment remains tough for fixed income investors. Hopes that we had hit a peak in rates in early May proved short-lived with the US 10-year subsequently surging once more to fresh highs. Persistently high inflation continues to drive fears that central bank tightening will remain aggressive.
However, the narrative has shifted and the markets now believe there are risks that central banks may try too hard to squeeze inflation, tipping the global economy into recession. This ‘double jeopardy’ of rising underlying yields and wider credit spreads, as a result of growth fears, has resulted in particularly poor performance for aggregate fixed income strategies. The Bloomberg Aggregate Index is down 14.3% year to date1.
Timing the turn
The big question for fixed income investors, as they position for the third quarter, is whether we have arrived at a peak in yields. It is notable that the 5-year, 5-year forward rate in US Treasuries is now back in the range seen in 2018, the last time the US Federal Reserve was in tightening mode. So a reasonable upward shift in longer-term rate expectations has occurred.
Figure 1: 1-Month Rates 1 Year Forward have Retraced from the Highs
At the front end of the curve there are also signs that the market has reached the stage where it feels that further tightening of policy, beyond that already priced in by markets, will precipitate an even greater chance of a recession.
Figure 1 shows 1-month interest rates in 1 year’s time, which is a proxy for the amount of policy tightening that the market believes will be delivered over the coming 12 months. There has been a decisive turn lower from the spike seen in mid-June. This is the case even for the euro money markets where the ECB has yet to deliver a rate rise and hints that the market is struggling to price in an even more aggressive path for rate rises. This should provide a near-term cap on yields until the path of the economy becomes clearer.
Questions will also revolve around the degree of credit risk that investors may want to take. US high yield, which yields more than 8.5%, may be appealing but will not perform well if we head into a recession in the coming 12 months.
As the May ‘head fake’ in bonds illustrates, trying to time the turn in markets is tricky. However, broadening the invested pool of bonds, by following strategies such as global aggregate, may be an effective way capturing the turn when it arrives.
We see three important areas for investors to consider when looking at global aggregate bonds.
In the bargain bin? Global aggregate bonds have sold off to an unprecedented degree (see Figure 2), with the 12-month return showing an even greater fall than at the time of the Global Financial Crisis (GFC) in 2008. For those investors who believe in the tendency for the market to mean revert, there is now a significant amount of upside.
Embrace diversity. Geographical diversity across the exposure should provide some stability, with Japan (12.6%) and China (9.1%) both notably more stable than US or European bond markets.
Don’t worry about the timing. The diversity of types of bonds within global aggregate indices should soften the need for precise timing of any swing in market momentum. For instance, if the global economy slows rapidly then any widening in credit spreads should be offset by the general decline in Treasury/government yields, which represent 60% of the index. As seen in Figure 2, the 12-month returns from the index (dark green line) often turn higher as the weaker growth period unfolds (light green arrows). Of the four US recessions since 1990 (outlined in the boxes), global aggregate returns rose above 5% during the growth slump in all cases except for the GFC, where the acceleration in returns only really coincided with the growth trough.
Figure 2: US Recessions and Global Aggregate
How to play this theme
The markets appear to have rejected the pricing of still higher rates, fearing that what is factored into the curve already is sufficient to cause a material slowing in economic growth. That said, as we saw in May, calling the turn in rates remains tricky.
One potential option is to look at broader strategies with more diversified risks. Global aggregate bonds have typically posted positive returns during periods of slower economic growth but could also prove less vulnerable to a sell-off if growth remains firm, as credit spreads should tighten. Having undergone some precipitous falls during the first half of 2022, there is certainly scope for a rebound. Investors who are interested in a global aggregate approach but feel uncertain on whether the USD can remain strong should consider EUR-, GBP- or CHF-hedged options.
To learn more about our global aggregate ETFs, and to view full performance histories, please click on the links below to visit their fund pages.
1 Source Bloomberg Finance L.P., as of 22 June 2022
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