THE BOND COUNTER-OFFENSIVE HAS BEGUN

FIXED INCOME MARKET ANALYSIS

After 2022, a year described as “annus horribilis” by bond investors, our analyses concluded that 2023 was likely to represent a secular opportunity for holders of fixed-income assets (see WIF of 24 October 2022). On the one hand, the expected returns were very high and, on the other, depending on the scenarios adopted, the asymmetry between risk and return had rarely been so advantageous. Eight months on, it's time to take stock.

Between October 2022 and June 2023, central banks continued to tighten their monetary policies. The key rates of the US Federal Reserve (Fed) rose from 3.25% to 5.25% (+200 bps), while those of the European Central Bank (ECB) and the Swiss National Bank (SNB) rose respectively from 1.25% to 4.00% (+275 bps) and from 0.50% to 1.50% (+100 bps). Interestingly, over this period, yields on bonds with maturities of less than 2 years rose slightly, while their 10-year counterparts fell (see Figs. 2 & 3). In both the US and Europe, the yield curve has inverted. The phenomenon is now so pronounced that it is close to its 1980-81 records (see Chart of the Week).

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Over the next few quarters, this inversion cannot be ruled out, particularly if the central banks go too far in tightening their monetary policy. Such a scenario would encourage the short end of the yield curve to rise. Conversely, it would penalise growth and inflation, causing the long end of the curve to fall further. However, the most likely assumption remains that the yield curve will steepen again, with the Fed ending its sequence of rate hikes on 26 July despite inflation being above 2%. For their part, the European central banks still have a few more turns of the screw to make, but they will also stop tightening their monetary policy this year.

Whether the extreme scenario materialises, or the central assumption prevails, the yield curve will have to steepen again, as it does after every historical inversion: quickly and extensively (see Chart of the Week). It will return to a "normal" shape, so as to satisfy investors' "preference for the present". Strategies such as Target Accrual Redemption Note or Steepener should logically gain in popularity with experienced investors.

• If bear steepening occurs, i.e. long-term rates rise, then bond investors will suffer.
• If bull steepening occurs, i.e. short rates fall, then bond investors will benefit significantly.

Our analyses clearly point towards the second option. Indeed, as long as the recession has not been averted and inflation is falling, it is unlikely that long rates will rise. On the other hand, central bankers could ease their stance and cause short rates to fall.

This conclusion is borne out by the ten previous phases of steepening (see Chart of the Week). Half of them took place during the decades of structurally rising yields, before 1980, and the other half after. In most cases, the Federal Reserve was forced to ease monetary policy, sometimes even making a "pivot" from its action of previous months. In all cases, holding bonds has been rewarding (see Fig. 4).

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Over the period from October 2022 to June 2023, bond investors had an interest in extending the duration of their investments. The returns speak for themselves. US Treasuries issued for a period of 7 to 10 years saw their prices appreciate by 6.7%, compared with 1.7% for those with maturities of 1 to 3 years (see Fig. 5). With yields unlikely to rise, duration should continue to pay dividends between now and the end of the year (see Fig. 6).

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While the investment environment looks favourable for bonds, particularly relative to equities (see Fig. 7), the road ahead is likely to be a bumpy one. The volatility regime for bonds has changed dramatically over the past two years (see Fig. 8). Normally, the further along we get in the process of tightening key interest rates, the less uncertainty there is about the magnitude of that tightening. This time is exceptional in that inflation is rising at an unprecedented rate and central banks seem to be lagging behind in their efforts to curb it. Volatility, as measured by the MOVE index, has already fallen since the US regional bank crisis in March and should continue to fall, but it will remain structurally higher than in the previous decade.

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In the corporate bond market, the risks are likely to be greater. In recent years, many poorly rated companies have issued leveraged loans with floating interest. When short rates were around 0%, all was well. But after a 500-basis point rise in 15 months, interest payments on these loans have soared. Cracksare beginning to appear. As the number of bankruptcies increases (see Fig. 9), spread will widen between high-yield corporate and sovereign bonds, which are regarded as a risk-free asset. Given current volatility, this spread could double (see Fig. 10). Investors will therefore prefer Treasuries to high-yield corporate bonds.

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Conclusion

Bonds have been performing extremely well for eight months now. Given the economic and monetary outlook, fixed-income investments are still the "opportunity of the century". In the current phase, investors are favouring sovereign bonds over corporate bonds and seeking to extend duration. With the yield curve sharply inverted, steepening strategies will be very popular in the near future.

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RETURN ON FINANCIAL ASSETS