Bond Compass

Fixed Income Outlook: Balancing Risks

It was a tough first half for fixed income investors – but what will the third quarter bring? Some trends will persist, such as high inflation and higher central bank rates but, importantly, growth momentum is slowing. In this environment, we see three themes for investors to consider in the coming months: adding duration, seeking quality through investment grade credit, and diversifying with emerging markets.

Q3 2022

The Risk Pendulum Swings: Taking on Duration

The more symmetrical risk around rates means extending duration back toward, or potentially a little longer than, benchmark makes sense for investors in US Treasuries. In Europe, the picture is less certain but growth risks and correlations to the US also point to taking on a little more duration risk.

The themes in Bond Compass over the first two quarters of 2022 revolved around short-duration positioning. However, following the aggressive back-up in US yields, is it now time to take a more balanced approach to duration?

We expect that many of the same negative themes from the past few months will persist into H2, such as stubbornly high inflation, tight labour markets and more tightening by central banks. These forces could yet push yields to new highs for the cycle but there are also some hints that the market believes the sell-off in bonds may have run its course.

  • The market has priced in a significant amount of policy tightening and there are fears that pushing further could tip some key economies into recession. The fall in PMIs, in both the US and Europe, has raised fears over a wider growth slowdown. It is unclear exactly how central banks will react to slower growth, given the backdrop of uncomfortably high inflation, but money markets are already pricing a probability that the US Federal Reserve (Fed) will need to cut rates in Q2 2023. Therefore, to generate momentum for another leg higher in bond yields, the market will want to see signs that growth is holding up despite rising policy rates.
  • As noted in the Q2 Bond Compass, even though bond yields had undergone a significant repricing at that stage, it was always unrealistic to expect them to stabilise given the Fed had only just started tightening policy. Longer-dated forward rates typically peak close to the end of the tightening cycle, not at the start. While there are almost certainly more rate rises to come from the major central banks, rates further up the curve now look to be at historically more normal levels – for instance the US 5-year forward of the 5-year Treasury rate is back in the range seen in 2018, when the Fed was last raising rates.
  • Summertime is here for many parts of the world and that often leads to yields falling back as the market factors in lower government and corporate issuance over the holiday period.

Figure 1: Fed Tightening is Well Underway and has Pushed Forward Rates Higher

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In summary, the market has run well ahead of central banks and now needs them to validate some of what is already priced into the curve. Some further clarification on the path of growth and inflation is needed before there can be another decisive move higher in rates. In other words, risks are more symmetrical for US and European bond markets than they have been for a long time. As noted by State Street Global Advisors CIO Lori Heinel and her team, in their update to the market outlook1, “While it is unclear whether we’ve seen a peak in the US 10-year Treasury yield, we’re certainly not too far from it. So it may make sense for investors to consider buying duration.”

Targeting the belly

Taking on some additional duration risk still makes sense if economic activity continues to slow. Central bank rates are likely to continue to rising but this should flatten the curve if the market senses that this tightening will, ultimately, have to be unwound. This should leave the middle part of the curve better protected, suggesting strategies that focus on the 5 to 10-year part of the US curve.

There are some risks – the US curve is already flat. Based on the long-term regression shown in Figure 2, the 2 to 10-year spread is around 150bp flatter than it would have been in 2008 given the level of the 1-year rate. This shows the impact of QE and the $5.8 trillion of Treasuries that the Fed owns. The risk is that, as the balance sheet size is reduced, we could see yields rise further out along the curve. However, the fact that the Fed’s holdings are likely to remain high for a long time to come, with an initial cap on the roll-offs of Treasuries of $30 billion per month, should mean that this is a very slow process.

Figure 2: The 2 to 10-Year Slope is Flat Given Where Short Rates Are

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In Europe, the ECB has yet to pull the trigger on a rate rise but has indicated that rates will rise in July and at subsequent meetings. Despite being at an early stage in the tightening process there are several reasons for pursuing a similar strategy of moving out of the very front end of the curve:

Europe looks even more prone to recession risks than the US, with high energy prices acting as a drag on both business and consumer activity. Shutdowns in China are also weighing on export growth to a greater degree than in the US. While the ECB will raise rates, it could be a short cycle.

  • Correlations to the US mean a decline in US yields should also drag European yields lower. For instance, the correlation on the levels of the 10-year Bund and Treasury is 98.6% over the past year.2
  • The steepness of the euro area curve means that there are greater rewards from extending up the curve, with the yield-to-maturity on Bloomberg 3-5 Year Euro Treasury Bond Index +45bp to that of the 1-3 Year Index.3

How to play this theme

SPDR Bloomberg 3-7 Year U.S. Treasury Bond UCITS ETF

SPDR Bloomberg 7-10 Year U.S. Treasury Bond UCITS ETF

SPDR Bloomberg U.S. Treasury Bond UCITS ETF

SPDR Bloomberg 3-5 Year Euro Government Bond UCITS ETF

Growth Dynamic Points Toward Investment Grade Credit

After a bleak start to the year for credit investors, with both government bond yields rising and spreads to them widening out, markets appear to have stabilised. There is still a high degree of market volatility but risks around Treasuries are looking far more balanced and this could provide more stability to credit during Q3.

Wider credit spreads allow investors to benefit from the higher yields on offer. The main risk to that strategy is that they widen further. Two of the key drivers of credit spreads are credit quality and volatility. Volatility is already high based on the ICE Bank of America MOVE Index of Treasury volatility. It is approaching the peak levels seen during the COVID crisis, which should limit any further increase. For credit quality, the market has already moved to price in a meaningful slowdown.

Figure 1 shows US corporate AAA and BBB spreads to Treasuries. They are slightly above the levels seen in late 2018 when the US economy was slowing post the Fed tightening cycle. It is a similar story for high yield, although the spread move has run a little further, suggesting that there is already some bad economic news in the price, although not a full-blown recession (quarterly growth never went negative at the end of 2018).

Figure 1: US Corporate Spreads Now Price a Slowdown, But Not a Severe One

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Given the aggressive path of rate rises that the Federal Reserve could deliver (a further 175bp of rate rises to the end of Q1 2023 is priced by money markets), growth concerns for 2023 will persist. This uncertainty means we favour investment grade (IG) exposures for now. While it looks like non-IG spreads have moved further, evidence that there is a clear turn in US CPI, alleviating some of the pressure on the Fed to continue hiking rates, or the discounting by the market of a more extreme slowdown needs to be seen to make the riskier areas of the credit spectrum appealing.

There are few signs of financial distress in IG. Figure 2 shows that US IG issuers still enjoyed a considerable degree of ratings upgrade momentum in Q2 2022.

There is a yield pick-up to US Treasuries of more than 150bp on the Bloomberg US Corporate Bond Index,4  meaning an all-in yield-to-worst of around 4.7%. The duration on corporate debt is slightly longer than for an all-maturities Treasury fund so, for those investors not comfortable with longer-duration positions, a maturity-constrained approach could be better.

Figure 2: No Signs of Financial Stress for Investment Grade

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Europe, the Land of Confusion

The situation in Europe looks less clear with many countervailing forces at work. Inflation continues to head higher and, with ECB official rates at -50bp, there is an urgency to get interest rates up. The ECB has pointed to a 25bp rate rise in July, followed by a potential 50bp rate in September. However, many ECB members are also acutely aware of slowing growth momentum. The surge in energy prices and tighter monetary conditions, which includes the end to new bond purchases, could well tip the euro area into recession. For this reason, there has been no real (public) discussion on terminal rates for the euro area to act as some sort of anchor to market expectations.

The credit markets already reflect the higher levels of recession risk in the euro area. With spreads to government bonds on the Bloomberg Euro Aggregate: Corporates index of close to 215bp, this is getting out to the wides seen during the COVID crisis (+247bp). In contrast, the repricing in euro non-IG credit does not seem as extreme, with spreads on the Bloomberg Liquidity Screened Euro High Yield Index approaching +700bp, still well short of the wides seen during the COVID crisis. In 2020, ECB buying capped the degree to which IG credit sold off. While new ECB purchases have come to a close, there will still be the reinvestment of proceeds from maturing issues, which should still benefit the IG credit sector.

The combination of the greater relative repricing of IG versus high yield, the risk of recession and the fact that the ECB will maintain its stock of IG credit means we favour IG exposures in Europe. However, given the lack of guidance on how high rates may rise, a shorter-duration profile may make sense to reduce price volatility.

ESG credit exposures could also help to reduce volatility. Over the past year, the volatility and returns of the Bloomberg SASB Euro Corporate ESG ex Controversies Select Index versus the straight market-weighted Bloomberg Euro Corporate Index have been similar. Over 3 and 5 years, however, the ESG strategy has typically delivered similar returns but with lower levels of volatility.

How to play this theme

SPDR Bloomberg 1-10 Year U.S. Corporate Bond UCITS ETF

SPDR Bloomberg SASB U.S. Corporate ESG UCITS ETF

SPDR Bloomberg SASB U.S. Corporate ESG EUR Hdg UCITS ETF

SPDR Bloomberg SASB 0-3 Year Euro Corporate ESG UCITS ETF

SPDR Bloomberg 0-3 Year Euro Corporate Bond UCITS ETF

Emerging Market Diversifiers

EM debt had a difficult first half of the year, with some material losses associated with the exclusion of Russian debt from portfolios. Following this decline there is scope for a rebound as EM debt, including China Treasury, catches up with the decline in US Treasury yields. It can potentially be used to enhance a portfolio’s running yield and reduce volatility.

It is always wise to be wary of emerging market (EM) debt during a Federal Reserve tightening cycle. However, the fact that many EM central banks were already well advanced in raising rates, and current account balances were not obviously a destabilising factor, gave investors some confidence. Indeed, EM debt held up well during the early part of 2022 but the chaos caused by war in Ukraine prompted a sell-off from which risk appetite has yet to recover.

This parallel sell-off with developed market (DM) debt has undermined one of the cornerstones of EM debt, that of diversifying portfolio risk. There were some idiosyncratic factors that hit EM more than DM, notably the invasion of Ukraine, which dragged Eastern European debt and currencies sharply lower. But there was already an unusually high degree of synchronisation, with COVID shutdowns having driven most economies into recession together and then a boom when the lockdowns ended. High inflation is also a global issue, related to supply chain disruption and tight labour markets. However, there are still places that are not entirely aligned with this global cycle, and that can provide diversification and some stability to portfolios. The China Treasury market is one such place.

As a fixed income allocation, China Treasury has drifted out of favour since yields were overtaken by Treasuries. However, the PBoC remains a long way from raising rates while DM central banks have some distance to go before their policy cycle comes to an end. As is evident from Figure 1, correlations of China Treasury bonds to other bond markets over the past 15 years have been low and, given the performance of the market for 2022 so far, the correlation remains low.

Figure 1: China Treasury has Low Correlations to Other Bond Markets

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There has also been plenty of noise around the CNY weakening. This appears to have run its course with the CNY remaining stable versus USD since early May, despite USD strength. The Bloomberg China Treasury 100BN Index, which is constructed around the most liquid China Treasury bonds, returned -3.31% in H1 2022 in USD terms, but for EUR-based investors the news was far more positive, with a return in EUR of +5.17%. This is a strong performance in an environment where the Bloomberg Global Aggregate Index returned -6.5% on an unhedged EUR basis .5

Scope for a Rebound in Hard Currency Exposures

The strength of the USD continues to weigh on local currency exposures. However, our view that US Treasury yields may have hit a near-term top gives us some confidence to look at USD-denominated EM debt. This approach has several potential benefits:

  • Historically high yields: Yields have risen with the yield on the JP Morgan EMBI Global Diversified Index is at its highest since Q2 2009. Moreover, due to the fact that central bank rates have risen globally, yield curves have flattened. This means that it is possible to get a high yield without taking on too much duration risk. For instance the ICE BofA 0-5 Year EM USD Government Bond ex-144a Index has a duration of less than 2.5 years with a yield of over 5.5%.6
  • Diversification: The ICE BofA 0-5 Year EM USD Government Bond ex-144a Index has 58 country issuers. A deteriorating global growth outlook is not a constructive backdrop for EM debt but the worst-rated issuers are excluded, with just 1.1% of bonds rated below single B, against more than 5% for the JP Morgan EMBI Global Diversified Index.7  This spread of issuers can assist in portfolio diversification: the ICE BofA 0-5 Year EM USD Government Bond ex-144a Index has had a correlation of just 16% to US Treasuries based off weekly data over the past 10 years, despite being a USD-denominated asset. It is also worth noting that many nations that issue USD-denominated debt are oil producers that receive a large proportion of their foreign earnings in USD.

Figure 2: Yield to Worst on ICE BofA 0-5 Year EM USD Government Bond ex-144a Index Close to COVID Highs

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