Fixed income

When the race is on during cycles

12 June 2023

By Michel Vernier, CFA, London UK, Head of Fixed Income Strategy

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below.

Key points

  • In the US, after a barrage of interest rate hikes, the peak seems to be not too far away
  • In the UK, more rate increases appear to be on the way – with inflation still a particular concern
  • History suggests that at this stage of the rate cycle, investment-grade bonds have typically outperformed cash by some margin. In the last five rate-hiking cycles, investment-grade corporate debt returned 25% in the subsequent two-year period, starting three months after the peak in rates was reached, compared with 18% for high yield 
  • However, timing the peak in rates is nigh on impossible. Nevertheless, it may be worth planning for a pause in rates, and then cuts, as the data dictates – as the window for locking-in yields could be limited

The first half of the year had plenty in store for bond markets. Rates climbed substantially after having retreated in the months before from the peaks seen back in October last year. In February, the rise in yields was spurred, once again, by inflationary pressures and concerns that the US Federal Reserve (Fed) might need to hike rates towards 6%. 

But, as always, different factors were at play, and it was ultimately the peak in rates which exposed the unsustainable business models of some regional banks. In March, Silicon Valley Bank (SVB) collapsed due to the wave of deposit withdrawals from clients who saw better, and safer, yielding opportunities elsewhere. 

The sale proceeds of SVB’s Treasury holdings were insufficient to meet the bank’s liquidity need, given the loss of value caused by the rise in yields. 

Between inflation and growth concerns

The market was quick to pare back estimates of terminal rates in this cycle, with increased concerns that the Fed has finally broke something within the financial system with higher policy rates. Indeed, a handful of medium-sized regional banks failed, but these concerns did not materialise, with the turmoil not turning into a larger banking crisis, as discussed in Deciphering banking codes

Consequently, the market once again shifted its focus to the inflation outlook again. The good news is that US headline inflation, but also in Europe and to a lesser extent in the UK, has retreated. The bad news is that core inflation has not followed this trend, and so central banks are unlikely to call victory yet.

Inflation risk remains

In this environment, the bond market seems to be torn between sticky inflation and further rate hikes on one hand, and negative repercussions to the economy due to tighter financial conditions on the other hand.  

This, in turn, has kept rates across the pond within a broad range: the last US rate peaks in October ranged between 3.35% and just over 4% for the 10-year government bond, and in Germany between 2% and 2.7% for the same maturity of debt.

What are the chances that these October highs could be breached again? History suggests that this will ultimately depend on the policy path of central banks and what the market prices for the future policy path. For medium- to longer-term rates to breach the highs, two factors are important: the remaining number of hikes and the timing of cuts further out. 

1. Amount of hikes

The Fed and the ECB have stressed during their latest meetings that policy decisions will be dependent on the economic data (a so-called “conditional pause”). Should the economy and the labour market prove to be more resilient than initially expected, then further hikes can certainly not be ruled.  

But as US Federal Reserve (Fed) member Austan Goolsbee commented: “There’s still a lot of the impact of the 500 basis points we did in the last year that’s still to come.”1 Meanwhile, Powell noted that the terminal rate did not seem too far away. 

With inflation in the UK only returning to single digits in April2, The Bank of England (BoE) must act quickly if it is to get on top of inflation. For a long time, the pressure for lower UK rates seemed to be greater, given the country’s economic vulnerabilities. 

The latest growth and prices data, however, shows that a recession might be averted in the short term, while core inflation is still on an upward trend, which changed the narrative leading to increased pressure for higher policy rate. 

Indeed, the rate market has started to price in more hikes with an implied terminal rate of 5.5%. Four hikes seem ambitious while two hikes appears very likely. While a banking crisis did not materialise the challenge of tighter financial conditions have not entirely disappeared which may limit the amount of hikes to a certain extent.

2. Timing of cuts

The biggest source of upward pressure for rates might be down to the market pricing in cuts  too early in America, in particular: the market expects five US rate cuts, compared with two  in the UK and eurozone within the next 12 months, from the respective implied terminal rate.  

This is clearly at odds with the Fed’s intentions. Jerome Powell said, during the central bank’s May press conference3: "So, we on the committee have a view that inflation is going to come down not so quickly. It will take some time. And in that world, if that forecast is broadly right, it would not be appropriate to cut rates. We won't cut rates."

Ultimately, the potential upward pressure for rates seems more contained in the US and Europe, than it is in the UK. In the first two-named economies, even a slightly higher terminal rate in combination with a somewhat longer period of peak rates may not necessarily translate into significantly higher rates levels as seen last October. However, in the UK, at least in the short term, this pressure seems to be greater.

The timing of cuts may be open to debate, and this may lead to temporary volatility, but policy-rate cuts will be on the agenda sooner or later and the broader disinflationary trend suggests putting a brake on much higher rates.

This begs the question, when is the best time to buy bonds, or should additional investment in bonds be avoided, given the risk of even higher yields? 

Historically, bonds have outperformed cash

Major bond segments have outperformed cash since 1983 (see chart). Cash has quadrupled in value in the last 40 years. However, bonds shot up in value by a factor of 15 over the same period, for example.  

Cash has underperformed substantially over the last 40 years, based on the US policy rate, constructed 3-months USD cash index based on Fed rates against major bond indices and S&P 500.

Bonds outperform cash 

The performance of US corporate debt, high-yield debt and government bonds against the fed funds rate and cash

The performance of US corporate debt, high-yield debt and government bonds against the fed funds rate and cash.

Sources: Bloomberg, Barclays Private Bank, May 2023

And still, even someone who invested in a US investment grade bond index in 1978 via Fund or ETF investments for example, prior to the so-called “great rate rise” during the 80s (when US 10-year rates rose from 9% to 16%) would have returned 9.7% per year over the subsequent five-year period, despite suffering temporary mark-to-market losses. 

Timing is key in the bond market

Admittedly, “time in the market” is not the only determining factor when it comes to bonds. Locking in yields at a yield of below 1%, as seen for almost all of the last decade, will return far less than doing so when rates are much higher naturally. 

In this case, the level of central bank policy rates are by far the biggest driver for general bond yields and so considering hiking cycles seems crucial. 

Catching peak bond yields again

The timing of peak bond yields was examined in our Outlook 2023: The road to normalisation for bond investors concluded that: “During past hiking cycles, including in the 1970s, the US 10-year rate usually peaked either at the moment short rates hit their top or slightly before, with the respective peak usually close to, or even below that seen in the policy rate.” 

While predicting the ultimate peak correctly is a difficult task, as The dangers of complacency found, peak US policy rates lasted roughly six months, on average, while two years later, the respective policy rate was only roughly 60% of the levels seen at the highest rate: this would suggest locking in yields rather waiting too long, only to find that rates are much lower than was expected.

Slicing the cycles

What does investing at, or near, peak rates mean for bond performance? And perhaps more importantly, wouldn’t it be better to stick to higher cash rates rather being exposed to market losses, if rates rise further or don’t fall swiftly?  

As the chart shows, during the last nine hiking cycles investment grade corporate bonds (based on the Bloomberg USD corporate bond index, with duration of around 6-8 years on average in dark blue) performed very well in the two years after the peak was reached. 

In fact, corporate bonds have outperformed cash, in all but two cases substantially, by over 12%, on average, since 1977. This is shown by the blue circle, with the outperformance shown as the respective value greater than 100 (grey area) against the performance of a strategy re-investing in cash or deposit rates. 

This outperformance was realised even when engaging three months prior a respective peak in policy rates has been reached: on average by 10% for investment grade corporate bonds in the subsequent 2-year period.  

Corporate bonds typically outperform cash ahead of a rate peak

The performance of US government debt, the fed funds rate and corporate bonds during the nine US hiking cycles since 1973

The performance of US government debt, the fed funds rate and corporate bonds during the nine US hiking cycles since 1973.

Sources: Bloomberg, Barclays Private Bank, May 2023

Taking a closer look at outperformance

A closer look at the performance ranges of corporate bonds in comparison with cash, but also other segments like government bonds, high yield bonds or emerging market bonds, seems justified. 

Not only have corporate bonds usually performed best, on average, in a two-year period beginning three months before the US policy rate peaked, but performance has been positive in any of the last nine cycles since 1973.  

The chart shows that cash returns appear to be more stable, and also value (at least on a nominal basis) was not lost, but this came at a cost, in the form of significantly lower average returns, as explained previously.

High yield bonds

While high yield bonds have racked up a positive performance, they underperformed other bond segments during the period. During the last five cycles (the period that historical data is available for) high yield bonds returned 18%, compared to the 25% achieved by investment grade corporate bonds over the same period. 

An 18% return may appear high, but then rates have been much higher than seen more recently. Taking on additional credit risk and underperforming by 7% on average against respective government bonds, reflects the underwhelming return.

The main reason seems to be the fact that the primary driver for performance is lower trending rates during the observation period, while high yield bond spreads likely trended wider going into a slower-growth environment, typically evident when central banks start trimming rates again, as mentioned in Credit cycle in the wake of the incoming rate tide

High yield bonds underperform investment grade bonds after hiking cycles

Comparison of how cash and major bond markets performed in the two-year period starting three months before the peak in the fed policy rate

Comparison of how cash and major bond markets performed in the two-year period starting three months before the peak in the fed policy rate.

Sources: Bloomberg, Barclays Private Bank, May 2023

The cost of waiting too long

While calling the peak in policy rates may be fruitless, history suggests that investing in investment corporate bonds should produce a positive performance, from an absolute and relative perspective, in times when policy rates are close to their peak. Waiting too long on the other hand may result realising only lower yields during the next cutting cycle.


Mid-Year Outlook 2023

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