Navigating Rates
Fixed Income Forward: October 2023
Bond yields finally look attractive again, but bond prices remain susceptible to more bouts of rate and credit volatility.
Investors who want to start accruing income at these higher levels for the long run may want to consider strategies that can also help manage duration and spread risk tightly in the near term.
The turning points of rate and credit cycles – when central banks are done hiking and credit metrics deteriorate – rarely occur in a straight line. This time around uncertainty is being compounded by the aberrations of the post-Covid economy, such as inflated household savings and corporate balance sheets. Bond yields finally look attractive again, but bond prices remain susceptible to more bouts of rate and credit volatility. Investors who want to start accruing income at these higher levels for the long run may want to consider strategies that can also help manage duration and spread risk tightly in the near term.
September was a bad month for most bond markets as central banks warned rates may have to rise further and stay higher for longer, and the rates sell-off has continued into October. Despite their traditional “safe haven” status, AAA-AA rated government bonds are on track for their third straight year of losses due to their higher duration risk. Fixed- and floating-rate credit assets maintained their year-to-date outperformance, driven mainly by higher yields and stable spreads.
Starting yields in credit, including emerging markets, offer historically appealing entry points and high-carry cushions that can help deliver compelling total returns over the long run – barring any single-issuer downgrade spirals or defaults. That said, from here we think the odds favour spread widening over tightening. Neither investment grade (IG) nor high yield (HY) bonds are pricing the adverse scenarios for debt serviceability and refinancing that would accompany a more severe economic slowdown.
With its shorter duration profile, HY can keep portfolios invested at the front end of corporate credit curves where creditworthiness can be evaluated with higher conviction. Currently, spreads look relatively tight based on our expected par-weighted global default rate of 1.8% for the next 12 months; the market consensus default rate sits higher at around 3%1, which would suggest around 100bp of spread widening from here. We see spread dispersion growing in HY, especially within sectors, with relative value offered by high-quality credits trading at wider spreads than similarly rated but less resilient names.
For IG, the good news is total returns going forward should be driven more by spread duration (bond price sensitivity to changes in credit spreads) than by interest rate duration. Keeping portfolio spread duration anchored can help lower volatility, and leave room to add risk if an indiscriminate sell-off were to materialise. At the same time, the more mixed bag emerging from the latest earnings season means there is outperformance potential from both sector (eg, financials and utilities) and issuer selection.
Fixed income market performance
Sources: Bloomberg, ICE BofA and JP Morgan indices; AllianzGl; data as at 29 September 2023. Index returns in USD-hedged except for Euro indices (in EUR). Yield-to-worst adjusts down the yield-tomaturity 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.
For rates, there are both near-term and more distant dynamics to consider. Core government debt with a maturity of one year or less already offers a highly liquid and competitive alternative to cash returns, in our view. Later down the line when the credit cycle takes a turn for the worse, a flight to safety and rate cuts should lift prices of the highest-grade shortmaturity government bonds and push their total return potential far above current money-market rates.
When considering country risk, we favour the high real yields (bond yields adjusted for inflation) of countries such as the US, UK and Canada that are lacking in places like Germany, Japan and China. We see a case for incrementally adding core duration to portfolios, but with 2-5 yr maturities rather than further along the curve. While the gap between short- and long-term yields has narrowed considerably, most curves are still inverted so there is still no (term) premium for holding longer bonds.
Moreover, shorter maturity yields are stabilising and gradually regaining their negative correlation to stocks. By contrast, longer maturity yields are turning more volatile (see Chart of the Month) as attention turns to unsustainable fiscal policies. This development also cautions against exposure to weaker parts of the euro area periphery, such as Italy. Without central bank purchases, the extent to which sovereign debt supply can be absorbed by the market alone remains to be seen.
In terms of yield curve shifts, we would anticipate 10s-30s steepening first since 2s-10s steepening may be constrained by near-term uncertainty. Peak inflation and peak rates are not locked in yet – nor is a recession followed by rate cuts in 2024. Yield curves could still reinvert if stubbornly tight job markets lift wage inflation, and rising oil prices spill into core inflation. Therefore, investors may want to consider maintaining modest exposure to longer-dated bonds, which could also rally in the event of an unforeseen global shock to the economy.
WHAT TO WATCH
1. Dispersion in credit quality
As the Q3 corporate earnings season gets underway, we’ll be looking out for signs of resilience or erosion in margins and interest coverage ratios, separating higher quality issuers from weaker ones who could also be facing additional pressure from unfavourable debt maturity walls.
2. Re-emergence of fiscal worries
Increased volatility in longer-dated core yields point to concerns around structurally (not just cyclically) higher budget deficits. This fiscal story may pull yield curves steeper, especially if central banks are no longer willing to provide a backstop by reinvesting their maturing bond holdings.
3. Direction for prices and jobs
Heading into Q4, Europe’s recently improved inflation outlook is complicated by a surge in oil prices. In the US, an unexpected jump in job openings poses its own challenges. How these factors play out will determine when this rake hiking cycle might finally begin to turn.
CHART OF THE MONTH
Source: AllianzGI, Bloomberg, data as at 29 September 2023. Past performance, or any prediction, projection or forecast, is not indicative of future performance.
The US Treasury (UST) curve has shifted sharply over the course of 2023. An initial drop in yields in Q1 reversed across Q2 and Q3 as markets finally relented to the Fed’s higher-for-longer message, with a 100bp upward shift across the curve since Q1
The more significant change in our view is increased volatility at the long end. As the bars of the chart show, the quarterly trading range of shorter maturity (especially 2yr) USTs has declined over the last two quarters, suggesting a welcome stabilisation of short end rates that should give investors more comfort in adding duration in that part of the curve
Conversely, the trading range of longer (especially 30yr) USTs has risen, a move reflected across other major rates markets as concern around deficits has re-emerged. Ultimately this long end volatility should result in a re-steepening of yield curves as the “term premium” for holding longer bonds is restored, but given the macro uncertainty this may take time to play out.
