Investor Sentiment: Is the Worst Over for Bond Investors?
This data captures behavioral trends across tens of thousands of portfolios and is estimated to capture just over 10% of outstanding fixed income securities globally.
Peak Rates but No Party Yet
Still low but rapidly rising interest rates, set against the backdrop of above average inflation and below average growth, are the stuff of fixed income market nightmares. A cursory glance at the fundamentals suggests that Q4 will be much the same. But the behavior of long-term investors suggests that the worst returns may be in the past.
Across the wildly volatile quarter, long-term investors were significant buyers of longer-dated US Treasurys. With holdings in maturities beyond seven years already quite elevated, this appears to be a high-conviction bet that peak US rates may be approaching, making it safe to go back into duration risk (cue the Jaws theme).
Equally notable is that, as much as behavior in the Treasury market encourages a pivot by the Federal Reserve (Fed), at least a peak in rates, we detect little optimism outside of nominal Treasury flows. Demand for Treasury Inflation-Protected Securities (TIPS) remains positive, perhaps as a hedge against surprisingly strong inflation — more on that in the PriceStats section.
Flows for riskier bonds, sovereign or otherwise, were still unusually weak. Italian BTP flows were in the 13th percentile for the quarter, emerging market (EM) local currency bonds were in the 10th percentile, and US high-yield flows were in the 9th percentile. Finally, and perhaps most surprising, long investors were net buyers of gilts, reducing the biggest underweight they’ve held in five years only to be caught out by moves at the very end of the quarter.
These behavioral patterns suggest that while investors are happy to add to their positions for a peak in US rates, they are for the moment less convinced that this will unleash a demand for riskier fixed income assets. Amid ongoing uncertainty, the bottom line is that investors view Treasurys, even longer-dated ones, as the safe haven of choice — now with a little more yield!
No Sign of Investors Being Fed Up with Treasurys
Q3 saw two more jumbo rate hikes from the Fed and aggressive forward guidance of more to come. But the higher that peak rate pricing goes, the more confident investors seem that a peak has been priced. Across the quarter, investors added to already unusually large holdings of longer-dated Treasurys. Given ongoing macro uncertainty and geopolitical risk, one could be forgiven for interpreting this behavior as a simple sign of outright risk aversion. However, the selling of 1-3 year Treasurys doesn’t fit the flight to safety narrative. Instead, the calculation appears to be that the peak in rates is close and any future tightening will simply lead to further curve inversion.
US investors are not alone in this belief. Foreign demand for Treasurys is equally robust, running at a rate close to five-year highs across the quarter. So far, the message is that the ever-strengthening US dollar (USD) and increasing cost to hedge US assets are doing nothing to deter international investors from purchasing Treasurys.
While risk aversion may not be apparent in the pattern of Treasury demand across the curve, it is clear in US credit. Demand for corporate bonds in the secondary market remains on the floor with no sign of moving. Interest in duration does not equal a return of investor interest in credit, it seems. Therefore, recession risks cannot be ruled out just yet.
The Gap in Investor Demand for Long-dated Treasurys and High-yield Credit Widens
European Sovereign Risk Increases
Ongoing economic disruptions from the war in Ukraine and wild fluctuations in natural gas prices continue to hang over European financial markets. While US markets debate recession risk, stagflation in parts of the eurozone and UK appears to be much more likely. With both the European Central Bank and Bank of England beginning to play catch-up on their tightening cycles, a difficult environment for European sovereign debt markets has been exacerbated by political developments in some countries.
Given that stagflation has been a risk in the UK for some months, it is no surprise that long-term investors had previously reduced their gilt holdings to the lowest level in nearly five years. Yet surprisingly, investors began to buy back this underweight across Q3. Quickly arrested by the government’s mini-budget, this trend comes too late to impact the quarterly flow aggregates reported here. Italian sovereign debt markets are also under pressure from a combination of stagflation and political risks. And while not as well positioned for weakness as they are in gilts, these long-term investors began to sell over the quarter to reflect growing macro risks.
Holdings of UK and Italian Sovereign Bonds Reflect Increased Risk
Still Waiting on Emerging Markets
In aggregate, EM assets are showing fewer signs of stress than might be expected amid the fastest Fed tightening in decades and a significant USD overshoot. This is testament to improved economic management and less USD-denominated debt. In spite of this resilience, as well as evidence that EM tightening cycles are maturing with tentative signs of inflation rolling over (we discuss this in the PriceStats section), long-term investor demand for local currency EM sovereign debt did not return this quarter.
Short-term (rolling monthly) flows briefly picked up toward the end of August as hopes of a Fed pivot began to build. But these proved short-lived as US data improved and the Fed re-asserted its hawkish stance in September. Accordingly, long-term investor flows into EM again dipped below par, even though holdings of EM bonds, especially in Latin America, are below average.
Demand for EM Bonds Pops and Flops
Fixed Income A type of investing, usually involving bills, notes or bonds, for which real return rates or periodic income is received at regular intervals and at reasonably predictable levels. Fixed income can also refer to a budgeting style that is based on fixed pension payments.
Inflation An overall increase in the prices of an economy’s goods and services during a given period, translating to a loss in purchasing power per unit of currency. Inflation generally occurs when growth of the money supply outpaces growth of the economy. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.
Yield The income produced by an investment, typically calculated as the interest received annually divided by the price of the investment. Yield comes from interest-bearing securities, such as bonds and dividend-paying stocks.
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