With their decisions, central banks have recognized that financial turbulence was an unwanted side effect of the rapid and large series of interest rate hikes that began in 2022. Monetary policy is now in tightening territory and inflation remains above target although price pressures appear to be gradually easing. Terminal interest rates appear close to 5% for the Fed, while the ECB would have a little more room to eventually make another cumulative 50 basis point hike in the coming months.
In this complex and volatile context, would the fixed income be back as markets have been announcing in recent months?
The opportunity to invest in the fixed-income market has become more pronounced as rates have returned to interesting levels in absolute terms, after many years characterized by ultra-loose monetary policy and negative rates. The revaluation has been positive for nominal interest rates initially and has been accompanied by a simultaneous movement in real interest rates in recent months. In this sense, with positive real interest rates in the US and in non-core euro bonds, the government bond market offers interesting levels of carry. Moreover, the high coupons financed by the new bonds grant a sort of “hedge effect” against further increases in official interest rates.
In addition, another significant factor to take into account would be that positions in core countries have offered an optimal hedge to investors when risk aversion has increased in recent months. While hedging against potential large losses in a negative environment, fixed-income investors should expect positive total returns in our central scenario, as we foresee a pause in the Fed’s monetary policy hiking cycle and, eventually, cuts in the following quarters.
Today, in the current environment, the fixed-income market offers a good entry point, as most of the yield curve is trading at very interesting levels. The carry effect is attractive, especially on the short end of the curve, as interest rates are close to the expected terminal interest rate of monetary policy. Although at historically high levels, bond yields also exhibit high degrees of volatility that could generate losses in a tightening approach to the market.
We recommend being selective in terms of quality and ratings: in terms of governments, our preference is for core countries such as Germany and the US. Although spreads on European peripheral bonds appear under control for now, we cannot rule out a pickup in volatility on these issuers. Similar reasoning could apply in the corporate segment, where we see value in Investment Grade and are less constructive on High Yield, as it might still be a bit early to start adding this asset class given the uncertainty in the market.
In this complex and volatile environment, investors should explore the relative value of the term structure of government bond curves. Diversification and hedging can also be added to portfolios through inflation-linked instruments, which protect investors against an unexpected price spike.
