Fixed Income Forward: February 2024

Markets point to bond rally lying in wait

Bond yields are generally higher now than they were at the start of the year, as major central banks have held rates unchanged and dashed market hopes for rate cuts before mid-year. This is no surprise given there are still no signs of a cyclical slowdown in the jobs market.¹ Policymakers must contend with the risk that a resilient economy could still interrupt the current disinflationary trend.²

Huge supply, and demand

As a result, bond market returns remain subdued year-to-date – except for floating rate, high yield and hybrid credit. Meanwhile, the prevalence of a “soft landing” outlook has encouraged huge supply of both sovereign and corporate bonds, which has been met with healthy demand. After the year-end rally, investors seem keen to access more rangebound prices, locking in higher coupons and extending duration in their portfolios before the next big drop in yields.

We’re also seeing healthy demand for ultra-long maturities, with yield curves having first turned upward-sloping between 10 and 30 years. Fast, back-to-back rate cuts would likely benefit longer bonds, but slower, more moderate loosening may limit their gains. We prefer to add interest rate duration in the US using the middle of the 2s-10s part of the curve, and to position portfolios to benefit from yield curve steepening, which can work as a longer duration proxy.

More cautious on euro duration

In the euro area, we prefer to add duration more gradually given stickier core inflation and a more cautious ECB policy stance. While Europe looks relatively stagnant compared to robust US growth3 and corporate earnings⁴ , this won’t necessarily be disinflationary going forward if it begins to bottom out. The ECB’s quarterly lending survey showed banks expect a small pick-up in loan demand for the first time since early 2022.⁵

In investment grade credit, we maintain a small overweight and a strong emphasis on issuer and security selection. Spreads have narrowed since the start of the year, with some sectors close to decadelong tights. We are focused on high all-in yields (rates plus spread) from high quality credits, which can offer a cushion against potential future spread widening. Europe looks more attractive on valuations, but we also see opportunities in longer US paper and local-currency Asian markets.

Source: Bloomberg, ICE BofA and JP Morgan indices; AllianzGI, data as at 8 February 2024. Index returns in USD-hedged except for Euro indices (in EUR). Asian and emerging-market indices represent USD denominated bonds. Yield-to-worst adjusts down the yield-to-maturity for corporate bonds which can be “called away” (redeemed optionally at predetermined times before their maturity date). Effective duration also takes into account the effect of these “call options”. The information above is provided for illustrative purposes only, it should not be considered a recommendation to purchase or sell any particular security or strategy or as investment advice. Past performance, or any prediction, projection or forecast, is not indicative of future performance.

High yield spreads look rich

We’re more defensively positioned within high yield as spreads are expensive, and we remain sceptical about the sustainability of “risk-on” rallies in CCC rated bonds. Euro spreads have outperformed the US year-to-date, with issuers attracting strong demand for refinancing 2025-2026 maturities. But Asia is the top performer so far, helped partly by a rebound in thinly traded distressed property names in China. We believe the default cycle is slowly coming to an end as policy measures help broaden developers’ funding channels.

Elsewhere in emerging markets, we’re staying active in the primary market where we see good fundamentals (eg. Benin), more scope for policy easing (eg. Brazil), and use-of-proceeds bonds directed at green or social objectives (eg. Ivory Coast).

Strong technical backdrop

Looking ahead, we see a strong technical backdrop for fixed income. The growing funding needs of debt issuers are being matched, with several trillions sitting idle in money market funds. Until the macroeconomic outlook becomes clearer, this favourable dynamic is enabling investors to diversify portfolios and prepare for all eventualities in the next rate-cutting cycle – be it fast or slow.

1. Services disinflation
The latest US Consumer Price Index (CPI) showed year-on-year core inflation in January stayed at 3.9% from December.⁶ Services costs excluding energy rose 0.7% on an annual basis compared to 0.4% the previous month. For the next leg down in inflation, we’ll be looking for prices in services to resume a downtrend since durable goods disinflation is plateauing.

2. China deflation
China’s GDP deflator, a measure of overall inflation in the economy, is now down three quarters in a row, the longest such streak since the so-called Asian Financial Crisis in the late 1990s.⁷ If deflationary pressures get more entrenched in undermining consumer and business confidence, more jolt-like stimulus measures may be needed for a sustained rebound.

3. Commercial real estate
New York Community Bank reported significant provisions linked to its US commercial real estate (CRE) book. While we view this risk as more issuer-specific, this has reignited contagion concerns in the market and warrants closer scrutiny of provisions and non-performing loans at other financial institutions with material CRE exposures.