Bond market road map: the path(s) ahead

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.

All data referenced in this article are sourced from Bloomberg unless otherwise stated, and is accurate at the time of publishing.

Key points

• After a solid but not exceptional year 2023, returns across the major bond segments are varied this year so far. More resilient growth and persistent inflation have once again pushed out the timeline for policy rate cuts.
• A ‘soft landing’ in the US and a moderate growth pick up in the EU and the UK (great convergence) seems most likely while rate cuts albeit with some delay should become reality ultimately. Such an environment (“not too cold and not too hot”), seems favourable for bonds.
• But the bond market seems to be already priced for perfection, and alternative scenarios could well transpire. The disinflationary trend could halt or inflation could even pick up. Equally, although less likely, a recession could hit any if not all major economies.
• A mix of medium-term investment grade credit in combination with other segments, like high yield (BB-rated), emerging markets and some inflation-linked debt, seems to be a reasonable approach to meet uncertainty over the upcoming path while delivering likely higher returns than cash over the long term.

After a solid but not exceptional year in 2023, returns across the major bond segments varied from -5.8% for ultra-long-dated US Treasuries, to almost 2.5% for US high yield and emerging market bonds this year. Dollar- and euro-denominated investment grade debt returned -1.8% and -0.2% respectively. 

More resilient growth, particularly in the US, and persistent core inflation, as seen lately in the UK, have once again pushed out the timeline for policy rate cuts. This, in turn, led to a re-pricing in the rate market.

Rate cuts postponed

The US economy seems to be heading for a ‘soft-landing’ while the eurozone and the UK should see a moderate pick up in gross domestic product (GDP) growth (what might be called the great convergence) and lower inflation, as analysed in our Macro chapter, ‘Global economy resilient in the face of headwinds’.

A rate cut by the US Federal Reserve (Fed) towards the end of this year seems likely, while three cuts may be on the cards in the UK and eurozone in 2024. The forthcoming cutting cycle could see the Fed, Bank of England (BoE) and European Central Bank (ECB) bring down their policy rates to 4.25%, 3.75% and 2.5% (deposit rate) respectively, though this would be higher than seen during previous cutting cycles.

Moderate growth and lower trending inflation, that is a climate that is not too cold and not too hot, seems to be favourable for bonds. As examined in our article earlier this year, ‘The right temperature for corporate credit?’, investment grade credit seems to perform particularly well against government debt if annual GDP growth is between one to two percent, as seen in the US since 1948. 

It could be argued that the above is all priced into the market already. First, the rate market implies moderate cuts rather than hikes, as shown by a mildly inverted yield curve (based on the US 10-year yield minus that on the two-year being -0.3%). Second, spreads (yield premium to government bonds) among US investment grade (of below 90 basis points (bp)) and US high yield bonds (close to 300bp), for example, are close to their tightest levels recorded in the last 20 years.

Does expensive pricing result in no or negative returns consequently?

No is the short answer. Rich pricing exposes mark-to-market values to volatility, should “things” not materialise as implied. But the main feature of bonds is that they deliver returns through coupon or yield and carry, rather than price gains. Investment grade yields in the US, eurozone and the UK are 100bp away from their recent highs, at 5.5%, 3.8% and 5.5% respectively. However, they are still at levels last seen fifteen years ago, showing plenty of yield still left (see chart)

Spreads tight but yields are high

US investment grade yields decomposed to rate and spread (to Treasuries) component

In addition, a likely slowing of global growth in coming months suggests that somewhat lower rates are on the cards providing additional price gains. Admittedly, every cycle is different, and the current environment has enough potential to deliver alternative scenarios. However, some are hard to quantify (like the US or UK elections), while others are difficult to judge what the impact will be (like fiscal policy or geopolitical conflicts). Not least because historical relationships between economic outcomes and asset returns appear to have been shaken up over the last three years.

Considering alternative paths

Given the higher uncertainty over future rate paths, it’s worth examining alternative scenarios, and their possible implications. One would be if the major economies avoid a landing at all or see some growth acceleration. Such a possibility seems more likely to occur in the US, compared to the EU or UK for example. Fed chair Powell would likely delay the easing cycle or would even have to add an additional hike or even two in such a scenario. 

Higher rate volatility would be on the agenda in particular if the new US government further stretches the fiscal boundaries raising debt supply concerns. A test of the recent highs for the US 10-year Treasury yields, at 5%, and renewed spread volatility could be possible outcomes. 

Given the positive fiscal impulse for the economy, higher spreads would unlikely persist and would mainly be seen in the loan market, as a result of higher funding costs. According to ratings agency Moody’s, companies at the lower end of the rating scale in the US must refinance around $393 billion of debt over the next three years (55% of the total). Overall, a no landing and persistent inflation scenario would favour inflation-linked bonds. But also shorter-term BB-rated bonds should do relatively well (despite expected volatility).

Every bond segment has its place

Change in performance of US Treasuries (UST), Treasury inflation-protected securities (TIPS), investment grade (IG), high yield (HY) debt and US-denominated emerging market (EM) debt, over the last decade

Markets are ignoring cycles

Another alternative scenario, would be that of a recession, which does not seem to be priced in by the market. Again, this is not to be confused with a larger crisis, be it macroeconomic or geopolitical in nature, but simply a deeper economic downturn with a substantial rise in the unemployment rate, as seen so often during cycles. 

Traditionally, central banks respond to downturns with deep rate cuts, regularly more so than implied by the rate market. Real policy rates of -1% to less than -1.5%, as seen in 2001 or 2008, appear to be plausible, which could translate to nominal policy rates of lower than 2% in the case of the Fed. Consequently, nominal long-term bonds would outperform while spreads would materially widen; potentially for a prolonged period. This is in anticipation of surging defaults among speculative grade credit given the historically strong relationship between defaults and unemployment. Meanwhile, investment grade bonds should deliver more stable performance, owing to their closer link to rates levels.

“Fanatically” diversified

The fact that the bond market is already priced for a soft landing does not suggest it is inappropriate to position for such a path. It just reduces the likelihood of exceptional short-term outperformance. As mentioned above, reasonable carry returns could still be achieved. 

Admittedly, the level of uncertainty seems high at this stage. Even Nobel laureate in economics Paul Krugman attested: “On interest rates I am fanatically confused.”¹ Alternative or adverse scenarios, as laid out above, can best be addressed via diversified and active strategies engaging in various parts of the bond market and by avoiding outright extreme positioning (such as being invested in just long-term bonds, or maintaining a focus on high yield bonds only).  

A mix of medium-term investment grade bonds in combination with other segments, like high yield (BB-rated), emerging markets and some inflation-linked bonds, seems to be a reasonable approach to meet the potential paths to come, as history has shown (see chart). Sticking to short-term ‘safe-haven’ debt over a long period to face all possible scenarios, meanwhile, seems to be a more questionable strategy.

Short-term bonds have underperformed significantly 

The performance of various sectors of the US bond market, and US dollar-denominated emerging market debt, shows that shorter-term maturities have lagged