Generali Investments: Short-term credit may be the winner at the end of rate hikes

In this interview, Mauro Valle, Head of Fixed Income at Generali Investments, discusses the upcoming monetary policy developments in the eurozone, specifically the ECB meeting in May, and the implications for fixed-income investments. Valle expects rates to move within the range observed in the past weeks and believes that the credit sector continues to offer attractive returns, especially on medium-short maturities.

What monetary policy developments are ahead for investors in the eurozone, in particular looking at the ECB meeting of early May? What should be expected from the ECB and which implications for fixed income?

The outlook for bond investments for the coming months is not negative: although volatility may still be high, the yields that can be obtained today are largely positive and able to withstand market fluctuations. We are now approaching the final phase of the monetary policy tightening cycle, and we believe that rates, in the next future, could move in the range observed in the past weeks. Even the credit sector, after the good performance at the beginning of the year, continues to offer attractive returns, especially on medium-short maturities, thanks to better macroeconomic prospects. The ECB is confirming its hawkish stance, but the market turbulences due to the tensions in the banking sectors and the risk of an economic slowdown accompanied by a decline in inflation are factors that should moderate the next central bank's decisions. After the latest hike of 50 bps decided in March, President Lagarde has clarified they will have no pre-committed decisions and the next steps will be data-dependent and subject to developments of financial tensions. At this point, the markets are pricing at a terminal rate of around 3.5% and it appears to be an arrival level consistent with the overall macroeconomics scenario and financial uncertainties.

What volatility to expect for the next months?

The impact of a high level of (negative) volatility was hard last year, after a long period of suppressed volatility by Central Banks' monetary policies. My impression is that in 2023 investors are now much more aware of the volatility risk present in the interest rates market. Episodes of high volatility should happen again during the year, as we have seen in March, due to several factors of uncertainty. The main risks are further financial tensions, an economic slowdown linked to a credit tightening process, and an unclear decline in inflation.

What makes European government bonds particularly interesting compared to other bond segments? What is the best way to generate returns in this environment? 

The government bonds are working again as a hedging factor in a volatile environment. During the turmoil we observed in March in the banking sector, rates registered a very large decline: for example, the Schatz rates moved down around 100 bps in less than 10 days. This decline compensated for the widening of credit spreads and the good quality IG corporate bonds gained despite larger spreads. Now the government bonds are offering a positive yield and a level of rates large enough to protect from market movements. We must think that fixed-income investments, also considering credit, can offer yields between 3% - 4% and that carry from yields is helping to amortize the effects of rates volatility.

What durations do you focus on?

Overall, the portfolios of our euro bond strategies are tactically positioned between defensive and neutral after the recent rates movements, as we have expectations of euro yields that should move in range in the next weeks, also if the onset of quantitative tightening by the ECB will not be as supportive. We continue with moderate exposure to euro peripheral government bonds, as the volatility of spreads during the last market fluctuations was quite limited. We are favoring a neutral duration exposure with Bund yields around the key level of 2.5%. As the German curve is always well inverted on the shorter maturities, we are suggesting to increase moderately the exposure to shorter maturities also because the ECB is close to the terminal rate.

How do you evaluate the other market segments, in particular corporate credit?

We think technicals and valuations are still both positive factors for Investment Grade credits, although seasonality and the recent volatility in corporate bonds warrant some caution in the coming weeks. As regards sectors, we continue to prefer financials over non-financials, with a preference for the short-term segment, but name selection is fundamental. Within the non-financial sectors, we will steer clear of segments likely to struggle more during 2023 such as steel, mining, and construction while we have a preference for defensive segments (utilities, telecoms). In general, considering the inversion of the interest rate curve to date, the short-term credit segment, which offers a yield practically in line with longer maturities, is probably one of the best investment areas in terms of risk return.