What’s next for the bond markets?
At present, inflation is the dominant influence in the bond markets. Yields have been rising noticeably, several interest-rate hikes are being priced in. But the longer the war in Ukraine continues, the bigger the negative impact on economic growth is likely to be. This means that the market environment will remain volatile. However, there will be opportunities for active asset managers.
The sea change in the bond markets continues as the negative yields that have been a defining feature for a decade gradually melt away. In the investment-grade segment, the volume of outstanding bonds earning negative yields stood at only around US$ 3 trillion at the end of March, compared with more than US$ 17 trillion at the end of 2020. Irrespective of all unresolved geopolitical tensions, market participants are weighting the potential impact of the sharp rise in inflation on monetary policy more heavily than the risk of an economic slump. This assumption is not without merit, given that inflation has been rising on a broader scale and more persistently than anticipated. The US Federal Reserve (Fed) is pursuing its normalisation course undeterred by the war in Ukraine. The central bank clearly stated its intention to tackle inflation and to prioritise this over potential risks to economic growth. With the exception of a brief period in the wake of Russia’s invasion of Ukraine at the end of February that saw a flight towards safety, the prices of government bonds from western countries thus continued to fall while yields rose correspondingly. Measured by the Bloomberg U.S. Treasury Total Return index, US government bonds recorded their weakest performance since the start of the calculation of the time series in 1973. From a level of 1.71 per cent at the start of March, yields on ten-year Treasuries climbed to more than 2.5 per cent within four weeks. Over the same period, yields on ten-year Bunds rose from minus 0.07 per cent to a temporary high of more than 0.70 per cent – an upward swing of historic proportions.
Proportion of bonds earning negative yields is shrinking significantly across the world
Bloomberg Global Aggregate index
Central banks focused on normalisation despite risks to economic growth
Notwithstanding the risks associated with the war in Ukraine, the market thus continues to anticipate a swift normalisation of monetary policy. By now, more than two interest-rate increases by the European Central Bank (ECB) and almost nine interest-rate increases by the Fed have been priced in for the current year. Union Investment’s economists believe that this is rooted in positive underlying economic conditions. The war in Ukraine and the associated sanctions imposed on Russia have driven inflation up further, especially on commodities such as gas, oil, coal, agricultural products and industrial metals. This effectively acts like an additional tax and thus slows down growth. However, our experts do not anticipate a recession, provided that the European Union does not decide to impose a complete embargo on Russian energy and that Russia does not follow through with its threats to turn off the gas supply. Moreover, Union Investment does not believe that the war in Ukraine will escalate to a point where a military intervention by NATO is triggered. Our economists expect the ECB to raise interest rates twice in 2022. Generally, it seems likely that the ECB will continue on its normalisation path as long as medium-term inflation expectations remain above 2 per cent.
With regard to the US, Union Investment’s economists believe that the Fed will raise its base rate by a further 175 basis points over the course of the year. By the end of 2022, the Fed funds target rate should thus have reached a target range of 2.00 per cent to 2.25 per cent. In addition, the US central bank is expected to adopt passive measures to scale back its balance sheet (quantitative tightening, QT) from May, meaning that it will let at least some of its bond holdings mature without reinvesting the proceeds in the market. This should allow the Fed to trim down its assets by up to US$ 95 billion per month. But it also means that the market will lose a key buyer, which is likely to add pressure, especially on long maturities. Recent statements indicate that the Fed is keen to reach a neutral interest-rate level as swiftly as possible in order to avoid monetary policy becoming an additional source of inflationary pressure. Against this backdrop, now is not a good time to invest in long-dated government bonds. Paper with a shorter fixed-interest period is likely to offer better opportunities.
Inversion of the US yield curve should not be over-interpreted
Conversely, it is important not to read too much into the fact that the US yield curve has become slightly inverted in parts. At the start of April, two-year Treasuries were yielding slightly more than their ten-year counterparts. This is a relatively rare occurrence and is sometimes regarded as a harbinger of a recession. But in this instance, investors should not overestimate the significance of this signal. Term premiums on US government bonds have fallen dramatically as a result of the Federal Reserve’s asset purchases. This alone has substantially increased the likelihood of an inversion. In addition, the US labour market remains in robust shape despite the rise in commodity prices, which has resulted in a marked increase in wages and keeps consumer spending supported.
Nonetheless, conditions in the bond markets generally remain challenging and highly uncertain. But an important takeaway is that a serious economic slump does not seem probable at the moment. The central banks can thus be expected to press ahead with their normalisation agenda, which most likely means that government bond prices will continue to fall while yields will keep rising. When it comes to managing the risks of a multi-asset portfolio, investors should also bear in mind that the characteristics of government bonds that have historically been beneficial for a mixed portfolio of equities and bonds are currently weakened. This is due to higher medium-term inflation and low interest rates in Europe, which create unfavourable conditions for government bonds. A substantial price correction will need to take place for bond yields to return to adequate levels. In addition, higher inflation also intensifies the correlation between equities and bonds and thus diminishes the diversification effect.
Credit market offers alternatives
Against this backdrop, it is a good idea to look for alternatives. On the fixed-income side, spread products and structured credits are currently worth considering, because rising inflation also drives up nominal economic growth. This is good news for bond investors, because it creates scope for improvement in credit quality. If companies do not take on further debt and simultaneously manage to reduce their debt ratio through nominal revenue and profit growth, the improved credit quality should gradually be priced in via narrowing spreads. Selected corporate bonds, including some high-yield paper, thus count among the most interesting investment options in the fixed-income market at present.
No sharp rise in spreads
Corporate bonds: spreads back to pre-war level
No sharp rise in spreads
Govt. bonds: declining spreads in second half of March
Bonds from the emerging markets offer attractive spreads but also come with slightly higher risks due to the pandemic situation in these countries and higher interest rates in the US. Regions that have already progressed quite far in their cycle of interest-rate increases are particularly attractive at this stage. Convertible bonds also offer interesting opportunities. Many convertibles that were issued in 2021 are currently trading below par value (in some cases significantly) and are generating substantial positive yields.
The slightly more complex market for collateralised loan obligations (CLOs) offers attractive diversification potential for institutional fixed-income investors and multi-asset investors with a medium-term investment horizon and a preference for investments with a shorter duration. The variable interest rate of CLOs provides a certain amount of buffer against a loss of purchasing power if inflation remains high and the central banks raise interest rates.
As at 20 April 2022.