The past two years have been memorable for investors in many ways, both positive and negative. In the run-up to 2022, inflation forced rapid interest rate hikes and this, combined with the war in Ukraine, severely weakened investor sentiment. Last year, in the light of current data, central banks completed their rate hike cycle and interest rates peaked, at least for the time being.
When the dust settles in the markets, the focus is always on the future, and so it was this time: amid the rate hikes, 2023 was an excellent year for fixed income investors, with almost all fixed income classes offering exceptionally high yields by historical standards. Now, many who enjoyed the returns in fixed income markets last year, as well as those who did not invest, are wondering whether the train has already left the station in terms of high total return potential and how to proceed with the portfolio's fixed income allocation in the year ahead.
The train has not left the station yet – and the journey is long
After a year of high returns, it is a relief for investors that the bond market continues to offer high return potential for the year ahead. Market interest rates that continue to hover high, combined with attractively wide yield spreads and expectations of falling policy rates, set the stage for another year of strong total returns.
Where should an investor now look for carry return? When looking at yield spreads, and particularly the relationship of yield spreads to the balance sheet of companies, the investment grade market stands out for its attractiveness. With low leverage, strong cash flows and good results, we do not expect yield spreads to widen this year.
Now, at the verge of falling interest rates, many people expect the best returns to be generated by bonds with the longest possible maturity, as these also carry the highest interest rate risk. The problem is the current inverted yield curve, which means that the shorter the bonds, the higher the risk-free rate. Therefore, as the maturity increases, the risk-free rate decreases. This is due to the expectations of interest rate cuts. Hence, the market has already partly priced the potential for interest rate cuts on long maturities. Investors should therefore turn their attention to short and medium-term maturity corporate bonds, while taking advantage of the inverted yield curve. As short market rates are very sensitive to changes in monetary policy changes, an investor can benefit from a fall in rates when rate cuts start by investing in shorter maturity corporate bonds. We expect the yield curve to normalize this year, specifically as the short end of the curve falls, leading to a slightly rising yield curve and as a result benefitting the short maturity investments more than the long maturities. In long end of the yield curve, the advantage for the investor is to lock in the current high yield for a long period, which has recently been reflected in the growing interest in the longer investment grade market in Europe.
Reservations about long-term government bonds due to relatively low yields
While historically cheap pricing is the current trump of the investment grade market, the attraction of the lower credit quality high yield market is based on its really high yield to maturity. Although high yield is tightly priced on a yield spread basis, the yield of about 7% is attractively high - even relative to the equity market's long-term expected return. The high yield at the time of investment provides a truly significant buffer against market volatility.
Although there is attractive return potential in fixed income still available, it is worth highlighting long maturity government bonds as an example for a less attractive fixed income market. Many investors perceive government bonds as the lowest-risk asset class and are right to do so when measuring default risk. However, risk in the fixed income market also arises through interest rate sensitivity (modified duration) and for long government bonds this interest rate risk is high. While central banks are about to start the rate cut cycle, current pricing does not give long rates meaningful room to fall from current levels - unless there are major negative surprises in the economy. Thus, the risk-return ratio of long government bonds in the current environment is weaker than shorter maturities and for this reason I see short and medium maturity investments as much more attractive.
All in all, we are living through another very interesting year (also) from the point of view of the fixed income investor. While economic news often turns to the timing of the first rate cut, today's change in the Euribor, or expectations of whether the European Central Bank will cut rates by 100 or perhaps 150 basis points this year, it is important for the fixed income investor to keep an eye on the horizon and think about the big picture. So what matters is the current high level of yields and whether interest rates in general will start to fall, not whether the first rate cut will come in April or June.
