Bridging the yield gap

Key points 

• Bond markets have started 2023 in better spirits, as investors price in lower peak interest rates in the US and Europe – mainly on the back of slowing inflation
• While uncertainties remain when it comes to the ultimate peak and the longevity of interest rates, it seems preferential to lock-in yields before the opportunity potentially vanishes  
• Medium-term bonds seem the most appropriate segment of the market to target in order to bridge the yield gap that is likely to emerge in coming years. This strategy may help mitigate the risk of re-investing into lower yielding debt, while mitigating the price risk taken by investing in longer-dated bonds
• Bond market yields are at the top of the range seen since 2012. We prefer investment grade debt and more value seems to be available in emerging markets again. Within high yield, we remain cautious, while noting the better spreads available in Europe and UK

With financial market expectations of the peak for interest rates falling of late, what does the outlook for rates, inflation and central bank policy mean for bond investors?

After the great repricing of the bond market last year, led by the short end and which saw the yield curve rapidly adjust to the need and determination of central banks to bring a turnaround in inflation, 2023 may finally bring the long-awaited and anticipated peak in policy rates. 

That said, there remains plenty of uncertainty around the ultimate peak, and its timing and most importantly longevity. But the good news is that some easing of inflation in recent data for each jurisdiction suggests that a period of excessively high inflation may be a phenomenon of 2022, but not for 2023 and 2024. With lower trending inflation, the certainty around the peak level of the respective central bank rates should increase accordingly. 

This greater certainty around the expected level of peak rates in the US and Europe is already visible in the overnight index swap (OIS) rate forward rate markets. The OIS yield curve shows the market has stopped adding further hikes, a common pattern seen in 2022, since late December, and instead show a fairly stable estimated level of the respective terminal rates (US Federal Reserve (Fed): 5.0%, Bank of England (BoE): 4.5%, European Central Bank (ECB): 3.5%). 

As central banks continue to hike, the gap between prevailing rates and what is implied by the market is slowly closing (see chart).

Since October, and as re-iterated in The road to normalisation for bond investors?  we highlighted the opportunities to “lock-in yields”; in fact, one of our biggest convictions given historically high yields and our outlook for slowing economic growth for the subsequent years. 

The bond market since late 2022 has started to celebrate the initial signs of what could be the great moderation of inflation (what might be called the “disinflation party”). The rapid decline of yields demonstrates that, as with life, the environment for financial markets changes; often more rapidly and by more than anticipated. Lower trending bond yields suggest that the opportunity window to pursue the “locking in yield strategy” is unlikely to last forever. 

Locking in yields should not be confused with the widely popular “short-term cash plus” strategy, which involves investing in short-duration instruments with additional yield pick-up (although valuable in its own right). Instead, we believe that a locking-in yields strategy should be pursued with medium-term bonds. 

To many investors, the advantage of holding short-term bonds seems more obvious, while the risk of holding cash or short-term bonds in the near term is usually ignored. Short-term bonds usually work well at a time of  higher trending or sideways trending yields. However, by focusing only on short-term bonds or cash, rolling respective investments at periods of very low yields can cause underperformance. It could even erode value, after adjusting for inflation, in a time of deep negative yields.

Interest rate risk still important 

On the other hand, interest rate risk, particularly for long-dated bonds, should not be neglected entirely. But as outlined we see only limited risk of substantially higher inflation, and rates, from here. 

The biggest risk to our base case view is that inflation moderates more slowly than anticipated by the rates market. The widely expected rapid easing is also a reason why longer yields are already falling compared to shorter-dated ones (leading to an inverted yield curve). Should inflation confound expectations and take longer to moderate, this would likely mostly cause a repricing at the longer end of the rate curve, as opposed to the medium or shorter end. 

Focus on medium-term bonds 

We are reluctant to extend duration to ten years or more, but rather feel more comfortable with medium-term bonds (generally with maturities of between four and eight years). By locking in yields over such a period, the biggest risk of re-investing (rolling) current term deposits or short-dated bonds at substantially lower yields can be almost eliminated: what might be thought of as bridging the yield gap. 

Even through the real-adjusted or inflation-adjusted lens, medium-term bonds seem reasonably priced. At current levels, and assuming that the inflation-linked debt market adequately prices future inflation (through breakeven yields), real yields in the US are well over 1%. 

Beware of more central bank policy errors 

After their record over the last couple of years, central banks may be prone to commit more policy errors this year. Last year one of the policy mistakes, in hindsight, was by not upping policy rate levels quickly enough, but instead clinging too long to the view that the initial surge in prices was transitory in nature.  

If there is a policy error to be committed going into the next cycle, we see the biggest risk being that central banks hike by too much, and potentially hold rates at a very restrictive level for too long, and thus risk a deeper recession occurring this year or next.  

The Fed, for example, has a poor record of adapting quickly to changing circumstances, as seen in 2019 and last year. In any case, in both prescribed scenarios, successfully taming inflation with a soft landing or risking a hard landing, bonds should perform comparatively well.

Inflation rates and economic growth are likely to retreat substantially this year. The main risk to that view, as outlined earlier, is probably a longer than expected period of high inflation, rather than a higher peak. Such a scenario points to larger long-term yields as opposed to higher short-term or medium-term yields.

Slower pace of rate hikes 

The BoE and the ECB are likely to follow the Fed with a slower pace of hiking (from 50 basis points (bp) to 25bp incremental steps) and all are likely to stop the hiking cycle this year. The major difference between their policy rate paths lies in the timing. In the US, a peak is likely to come earlier, as December’s inflation data hint that core inflation (excluding volatile food and energy components of inflation) seems to be slowing. While some components of inflation, like shelter costs, may still climb, and the job market is still very tight, early signs of an easing are evident. 

US Federal Reserve

Should the Fed’s own inflation projection of core personal consumption expenditures (core PCE) at 2.5% in 2024 materialise, its own projection of rates at 4.125% in 2024 may already be too high. In addition, this scenario ignores the risk of a “hard landing” for the economy, which could force the Fed to cut rates to an even lower, more accommodative, level. 

While we do not want to bank too much on a continuation of declining yields, the level of current yields certainly does not appear to be too low in our view. 

Bank of England

In the UK, inflation, and in particular core inflation, has not moved in the direction that the Bank of England wants yet. This, in turn, adds pressure to the notion of front-loading rate hikes swiftly to counter any wage spiral. Rate hikes would act mostly as a signal to the labour market. 

The rate market prices in a terminal peak at around 4.5%, which seems realistic. But compared to the US, the UK economy is very vulnerable due to the housing market, effect of elevated mortgage rates and the cost-of-living crisis. While a recession may be averted, growth is likely drop well below potential growth, making swift and potentially drastic rate cuts much more likely at some point; a reason to lock-in rates now. 

European Central Bank

In Europe, the ECB has turned more hawkish, and also when compared to their UK and US counterparts, while the economy is prone to dip into a recession, suggesting that rate cuts are in order at some stage. As in the US, inflation has already started to moderate and while the ECB may front-load hikes, the time available for raising rates may quickly come to an end. 

Do current yields offer value? 

With potentially lower yields, the question is what kind of yields can be expected and do these seem reasonable. Our table shows average yields in various bond segments. It also highlights that yields are well above their respective 10-year average. Indeed, in most cases, yields are close to the highest level seen in the last 10 years (over or close to the 90th percentile). 

Do bond spreads offer value?

Many bond markets offer above-average spread valuations another important factor when assessing overall bond yields. That said, differentiation between the segments is key. While US spreads of 122bp within investment grade bonds seem unappealing, the peak in corporate investment grade bond yields rarely coincides with the peak in spreads but rather with peak in rates (see Catching peak bond yields). 

Waiting for higher spreads to emerge in the investment grade bond segment may come at the cost of lower overall yields. In that respect, EU and sterling investment grade bonds appear attractively valued on both measures.

Turning to high yield debt, we are less convinced, given that spreads usually make up a greater proportion of the yields within the segment. We expect more spread volatility going into the economic slowdown, and given this backdrop, US high yield bonds in particular seem to offer the worst value against their peers. That said, pan-European high yield bonds, including sterling high yield, seem to offer better opportunities than US ones and a more appealing outlook for returns. Given the risk in the respective economies, a selective approach however seems justified. 

Emerging markets (EM) countries face different challenges, but overall, EM starts to look more appealing from a pure valuation perspective. With a possible peak in the US dollar and US rates, and a potential top in local central bank rates, the segment starts to offer more opportunities again. 

As always, the peak in yields is hard to predict. While many are keen to brag about having locked in very low funding or mortgage rates, the same is less prevalent when locking in higher yields on the investment side. A shame, given that long-term portfolio return would benefit on a risk-adjusted basis.