Fixed Income Outlook for 2024: What Lies Ahead?

Colin Finlayson, Euan McNeil, and Rachel Ward, from the fixed income team at Aegon Asset Management, analyze the prospects for sovereign fixed income, investment-grade credit, and high-yield credit in 2024.

Sovereign Fixed Income

Colin Finlayson, Investment Manager, Aegon Asset Management

After enduring constant pressure in the past two years, the outlook for sovereign fixed income has substantially improved. Factors that weakened government bond prices, pushing yields to the highest levels in over 15 years, are calming down and turning more positive. With interest rates firmly anchored in restrictive territory and clear progress in the fight against inflation, it appears that major central banks (the Federal Reserve, the Bank of England, and the ECB) have reached the end of their respective tightening cycles. Recent data suggests economic growth is slowing, and risks seem to be tilting to the downside, leading to expectations that central banks will cut interest rates in the near future. Simultaneously, attractive valuations are supported by investors seeking high-quality income or alternatives to cash, which are expected to decrease soon. The combination of these factors provides a solid foundation for government fixed income to perform well in 2024, supporting a long duration position in anticipation of interest rate cuts. The flattening of the yield curve increases the attractiveness of short-term bonds, as curves are expected to steepen in the next phase of the economic cycle. The macroeconomic environment favors core interest rate markets. Although the pace of inflation decline in Europe and the deterioration of economic activity in the UK might justify the ECB and the Bank of England easing their monetary policies sooner, headwinds facing the US economy and higher yield levels could lead treasuries to lead declines in 2024. The speed and extent of economic slowdown will determine how far government bond yields can fall, but even if the deceleration and the rate-cut cycle are moderate, sovereign fixed income will offer attractive returns.

Investment-Grade Credit

Euan McNeil, Investment Manager, Aegon Asset Management

The outlook for investment-grade (IG) credit markets in euros and pounds has been inevitably tied to global interest rate prospects and the ongoing debate on how long interest rates will remain restrictive. For most of the second half of 2023, we have maintained that the threat of inflation is easing, especially in the US and Europe, reducing the likelihood of further rate hikes each passing month. The economic slowdown in continental Europe has been observed in recent months, and there are indications that activity is also slowing in the United States. We believe these trends will continue in the early months of 2024, and central banks will need to cut rates in the next 12 months, supporting IG credit spreads in both euros and pounds. As cash, as an asset class, loses appeal in this environment, we anticipate that the likely market rotation towards IG credit will be a very positive technical factor. Generic valuations (in terms of yields) remain as attractive as in recent years, and we see potential for cash and IG credit yields to increasingly diverge, further reinforcing this argument. We believe this environment will be particularly favorable for subordinated financial instruments (higher-yielding). We are aware of the risks that threaten our outlook, although we believe the probabilities of their occurrence are low. If the economic recession turns out to be less gentle than expected, we would have to reconsider our approach.

High-Yield Credit

Rachel Ward, High-Yield Specialist, Aegon Asset Management

We believe the high-yield market will offer interesting opportunities based on attractive yields and a strong fundamental starting point. However, we recommend caution as macroeconomic headwinds persist. While companies continue to face fundamental pressures, most high-yield issuers have maintained robust fundamentals despite high inflation, with sound balance sheets and a good position to weather a recession. Although leverage has increased and interest coverage ratios have deteriorated over the year, on average, credit parameters for most companies started from historically solid levels. Moreover, many have managed to maintain their margins despite inflation. As the economic cycle progresses and the economy slows down, we expect to see increasing divergences in the high-yield market. However, we believe many high-yield issuers are well-positioned to handle a mild recession. We anticipate an increase in defaults, but not to the levels seen in previous recessions, thanks to the strong fundamental starting point and the higher quality of the market. Nevertheless, the market is becoming more divided, and we anticipate the gap will widen in 2024. Weaker companies with lower margins and little room for error are the most vulnerable. Although the 2024 maturity wall is manageable, troubled issuers may struggle to access capital markets and refinance upcoming maturities. For this reason, we are being cautious and highly selective, as idiosyncratic situations create more dispersion in the market.

From a valuation standpoint, we still favor high-yield bonds with yields above 8%. While it is unlikely that spreads will narrow significantly in the short term, the asset class remains attractive in terms of yield. Historically, the minimum yield to worst (YTW) of the index has provided a reasonable estimate of five-year returns. Considering that the current YTW of the index is above 8%, high-yield credit is attractive for long-term investors, provided they can tolerate some short-term volatility. Furthermore, the structural investment thesis in high-yield credit has not changed, as it continues to offer returns similar to equities with lower long-term volatility. Given the high macroeconomic uncertainty, we anticipate that volatility will also be high in 2024. Credit spreads may tend to widen in the short term, but we believe underlying yields will offset these movements. Additionally, market anomalies should create attractive entry points. If active managers can balance prudence and optimism, they may discover interesting opportunities next year. Now more than ever, we believe that selecting securities without reference to any index will be key to generating returns in the high-yield credit market.