Locking in
Bonds issued before the Federal Reserve (Fed) started raising interest rates will mostly redeem at par and thus see prices increase, and those issued since have higher coupons. The combination means that fixed income returns should remain positive for the near future. For those institutional investors that favour a buy-and-maintain approach to matching bond cashflows against their liabilities, the market has not been as well set up for many years. Issuance has been strong in most corporate credit markets in 2024, giving investors plenty of opportunities to lock in yields.
Risks from spreads rather than policy
What could go wrong? For now, we can rule out higher interest rates. Europe – via the guise of the European Central Bank, the Swiss National Bank and the Swedish Riksbank – have already started the easing cycle. The Fed and the Bank of England should not be too far behind. At the very least, fears of further rate increases, which were prevalent in the spring have subsided. Lower interest rates are locked into forward markets.
Eyes on Paris
A key risk to bond markets in the near future comes from Europe. The uncertainty over France’s budget trajectory – because of the current political situation – has already led to an increase in French government bond yields relative to German yields. Market and European institutional pressure might eventually contain the policy proposals currently being discussed in the election campaign but there is a risk of spreads widening further if markets get a sniff of a new government trying to implement tax cuts or spending increases which would lead to the French public deficit moving in the wrong direction.
A more optimistic view is that cohabitation in France after the upcoming National Assembly election will constrain the more radical proposals. The spectre of what happened to UK markets in September 2022 when then-Prime Minister Liz Truss implemented a populist Budget will have not gone unnoticed in Paris. If this is the outcome, any contagion in other European government bond markets or in credit markets might be potential buying opportunities during the summer.
Credit itself looks fine
The other risk is that we begin to enter a period of generalised credit deterioration. For some time, there has been evidence from the US of increased delinquencies in areas like revolving consumer credit and credit cards, while the issues surrounding commercial real estate are well known. There have been some distressed situations in high yield as well, but, so far, these have been idiosyncratic. However, should economic data continue to soften, and a harder landing become more evident, credit risk indicators would start to flash, with spreads on cash bonds and credit default swap indices widening.
If the carry-to-volatility relationship is very benign now, it is most likely to worsen because of higher volatility on credit spreads coming from concerns about a weaker economic outlook, the corporate earnings cycle turning softer, or policy uncertainty becoming more material. The good news is none of this is evident today. Equity markets continue to perform well – even though they are skewed by technology stocks – and demand for credit remains extremely strong. The recovery in fixed income returns looks set to continue.
Summer arrives (2)
The Euro 2024 football championship looks incredibly open. So far, Spain is the only team that has won all its group games and teams like France, the Netherlands, Italy and England have been far from convincing. The knock-out stages can be quite different – and I am sure they will be. But it has been entertaining and the fans have been super. The remainder of the tournament, the beginning of Wimbledon fortnight next week and then the Olympics might be further reasons why markets stay calm until September. And while past performance does not guarantee future returns, it is perhaps worth noting that in 15 of the last 20 years there has been a positive return from the MSCI World equity index in the month of July.
(Performance data/data sources: Refinitiv DataStream, Bloomberg, as of 25 June 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns.