The month of March reminded us that the path for fixed income is rarely a straight line. During this period, the market faced a rare and simultaneous hit on two fronts as sovereign yield curves shifted sharply upward and credit spreads widened.
While this double blow was undoubtedly painful for many portfolios, it is important to view it as a short-term reaction to the shock rather than a permanent loss of value. Looking past this immediate noise, it is worth recognizing that meaningful yield protection was already a feature of the market before the current conflict began. The pre-war carry was already providing a necessary cushion for long-term total returns, but the recent market shifts have pushed these levels even higher, significantly strengthening the defensive profile of the asset class.
The war in Iran has introduced a sudden shock to the global energy supply. For Europe, the primary concern is that high energy prices will translate into persistent inflation, forcing a reassessment of the European Central Bank (ECB) trajectory. Before the war, the market expected the ECB to keep rates unchanged at 2.00% through 2026. However, the market is now pricing in two rate hikes, and during the peak of the March chaos, it briefly priced in as many as four. While the geopolitical situation causes significant uncertainty, capital markets are forward-looking. A recovery does not necessarily require the war to end; the level of escalation is key. As long as the intensity of the conflict begins to ease, the market should find the footing to perform.
A Deepened Buffer in Uncertain Times
The recent volatility has not so much created a yield cushion as it has significantly deepened the one that already existed. While there was already a baseline of protection, the current yield levels offer much more robust insulation against further volatility. This environment stands in stark contrast to 2022, the last time we experienced a simultaneous upward shift in yield curves and spread widening. Back then, while the war in Ukraine reinforced a surge in inflation that was already underway, the starting point for credit was exceptionally difficult. Investment grade yields were as low as 0.5%, offering virtually no cushion to absorb the impact of rising rates. Today, our starting point is fundamentally higher, providing a far more resilient foundation.
In the short term, investor sentiment and central bank monetary policies drive the market, but for corporate bond performance, credit fundamentals are the ultimate gravity. Even high-quality credits can show weak performance in short periods, but in the long term, strong and improving credit metrics lead to spread performance. We find that for short- to mid-term maturities and high yield bonds, the initial yield at the time of investment serves as a reliable guide for the expected range of total return potential. By contrast, the investment grade market’s longer duration introduces interest rate sensitivity that complicates forecasting, as returns there are more heavily influenced by underlying yield curve shifts.
The "Rumsfeld" Factor
March saw significant upward shifts in sovereign yield curves, which was particularly hurtful for shorter maturities. The repricing of ECB hikes caused the short end of the German yield curve to rise much more than the long end. However, this has also created an opportunity: short-maturity crossover corporate bonds are now priced above 4.0% yield to maturity, offering a significant buffer against both yield and spread volatility. Forecasting short-term moves in an environment filled with what the late Donald Rumsfeld famously called "known unknowns" and "unknown unknowns" is very hard, but the beauty of fixed income securities is that visibility for the next 12 months is much clearer with short-maturity bonds.
If the ECB hikes twice as currently priced and ongoing uncertainty keeps spreads at these elevated levels, then the total return potential should align with the current yield of approximately 4%. Simulating a bad scenario, we could stress the market with four hikes and 150 basis points of spread widening—a violent move that would take yields well above the worst moments of the 2023 inflation surge. Even then, the yield rise to those levels would produce a total return of around zero, highlighting how the current elevated yield level is cushioning the impact.
As for the positive case—and here I admit my professional bias—as a fixed income portfolio manager, I am naturally inclined to focus on what could go wrong rather than how well things might go. That kind of unbridled optimism is perhaps better left to our colleagues in equity side. However, if I were to dip a toe into the "optimist pond," a recovery of just half the recent move in yields—whether through spread tightening, moves in the underlying yield, or a combination of both—could produce a 12-month total return potential of approximately 5.0%.
Please note that the figures and scenarios discussed above are strictly hypothetical illustrations derived from current market pricing and trends. They are intended to demonstrate potential market mechanics and do not constitute formal forecasts or guaranteed total return expectations. Furthermore, the information provided in this text is for informational purposes only and is not intended as, and should not be construed as, an investment recommendation.
Nordic Resilience and the Long-Term View
While European markets faced wild yield volatility, the Nordic corporate bond market remained remarkably calm. This is largely due to the structural dominance of floating rate bonds in the region. While credit spreads widened in sympathy with Europe, the coupons on these bonds reset higher as rates rose, meaning they did not experience the same price swings as fixed-rate securities. Furthermore, the Nordic high yield market showed strength during March with healthy primary market activity. The yield pick-up compared to the European high yield market provided the icing on the cake, adding further cushion for total returns in an uncertain environment.
Negative returns are never welcome, but we prefer to look at the horizon rather than the rearview mirror. The landing spot for yields in March has made fixed income, and the corporate bond market especially, very attractive. Investment grade yields at 3.5%, short-maturity crossover at 4%, European high yield at 6.4%, and Nordic high yield at 6.8% are compelling levels when assessing asset allocation. This environment opens an excellent opportunity for the patient investor to lock in these higher yields and enjoy the carry return over the coming years.
At Evli, our credit selection has always been based on a long-term view. When we add new names to our portfolios, we analyze their potential across entire credit cycles, preparing ourselves for both good and bad times. We continue to believe that strong credit fundamentals remain the ultimate driving force of spreads and eventual total return. We do not know when the war in Iran will be over and oil shipping will return to pre-war levels, but current yield levels already reflect that uncertainty, and the market reaction following the recent ceasefire announcement shows how quickly credit can react to positive developments.
