Por Raymond Sagayam, chief investment officer of fixed income at Pictet AM
Bond markets are at their most attractive state of years, in some cases decades. Indeed, although volatility and stagflation risks are a danger and accidents caused by central banks cannot be ruled out, fixed income investors are once again compensated by risk, an extraordinary change. Now, even an economic slowdown is compensated and for adventurous investors it is possible to imagine that some riskier fixed income segments are going to be attractive long-term opportunities.
Keep in mind that over the past decade bonds have traded at unsustainably expensive levels, with three-quarters of sovereigns richer country yielding negative. Now, in a few months, the ten-year real yield in the US has gone from minus 1% to 1.5% and in the UK from minus 2% to 2% positive. Changes of this magnitude only occur between generations. Indeed, in modern investment history, it has been attractive to invest at real interest rates of 2% in developed fixed income markets. At this point, U.S. Treasuries yield is rapidly reaching reasonable prices, especially in short-term maturities. Investors may suffer further significant falls in bond prices and still earn real positive returns. Other G-10 central banks are lagging behind in monetary tightening, but their bond markets must also reach fair value in the coming quarters.
Preference for low sensitivity to changes in interest rates and high quality
However, caution is warranted, given the geopolitical and macroeconomic turmoil and volatility. It is necessary to be selective and for now we have a preference for bonds with low sensitivity to interest rate variations and high quality, including short-term maturities corporate debt.
One reason for caution is that even if inflation moderates, it is unlikely to fall as fast as central banks hoped and there is a risk that interest rates will remain uncomfortably high longer before inflation returns to the central banks’ target, 2% in much of the developed world. Central banks used the wealth effect to prop up demand after the great global financial crisis of 2008 and are now likely to use the negative effect as a tool to suppress demand and inflation. In any case, interest rates at high levels are unlikely to be as long as in the era of low interest rates.
The fact is that the markets discount a maximum in US interest rates at 5% the first half of 2023, followed by monetary easing. This is optimistic, given price pressures and a tight labour market. But the US is further from stagflation than the Eurozone. However, a very sharp falls in asset prices may be necessary for the Federal Reserve to change its tightening policy. It already happened in March 2009, when it was the crisis in the credit markets, rather than the 60% fall in share prices, that caused its extreme monetary policy. Currently, if higher-maturity bonds becomes dangerously volatile, you can buy them and at the same time sell short-term bonds, a neutral monetary stimulus measure. But a new response in the form of quantitative easing is unlikely.
Even the Bank of England has been forced to buy UK government bonds to stabilise the long-term debt yields when the market panicked at former UK Prime Minister Liz Truss’ profligate approach given fears of a collapse in pension funds, over leveraged and with exposure to local debt.
The fact is that historically, at this stage of the cycle, in which interest rates continue to rise but inflation stabilizes, favours sovereign debt of developed countries, although its attractiveness varies depending on real yields, currency and degree of vulnerability to capital flight, which depends on the amount of debt held by foreign investors. which is different by country.
Investors should not be seduced by low corporate debt default rates
However, an avalanche of corporate debt will have to be refinanced, especially since 2024. It will be done well in advance, especially if there are concerns about increase in yield spreads over government debt and borrowing costs. Investors should not be seduced by the low default rates on corporate debt, even if there are opportunities in short-term maturities, as they are lagging behind the increase in spreads in six to twelve months. Keep in mind that equity and credit markets tend to move together under difficult conditions and that credit and stock market crises tend to coincide. So far, the S&P 500 stock index, despite losses in the year, shows relative stability given the stress of the market, reflecting that profits and margins have been maintained. But companies are vulnerable to inflation, rising debt costs, weakening growth and, in the case of the US, a stronger dollar. So far, institutional investors, who entered equities in 2022, have hedged or sold positions, which is why volatility in equities has been contained. But the “insurance” of central banks, which have intervened in recent decades, is no longer likely.
Look at emerging market debt
However, unlike previous periods of risk aversion, emerging market currencies have been relatively resilient against the dollar. More than 80% of real yields to maturity in emerging market debt are already higher than that in US debt, as their central banks are ahead of the curve in fighting inflation, having acted considerably more aggressively than those of the G-7. As U.S. interest rates stabilize, the dollar should move away from its high overvaluation, which may provide a boost to emerging market debt in local currency. In addition, emerging market corporate debt leverage is relatively low, being high-quality debt and now more held by domestic investors than in the past, therefore less subject to liquidation. So both emerging market debt in dollars and in local currency deserve a look.