Bond markets remain resilient and opportunities emerge in credits
Investor demand is suppressing long yields. An inverted yield curve may simply reflect investors’ recognition that yields are at generational highs
AS EXPECTED, the market was due for a rest after the strong interest-rate rally in the fourth quarter of last year. Indeed, the longer-duration and higher-quality segments of the bond market registered negative returns in Q1.
However, the rally in credit products powered ahead, thanks to stable fundamentals and strong demand from retail, pension, financial and overseas investors.
The demand for yield was so strong that the higher-risk segments of the market, such as high-yield corporates and hard-currency emerging markets, posted strong positive returns despite the increase in government yields. And, although the tightening in investment-grade spreads was far more modest, it was impressive nonetheless, as it occurred in the face of record supply.
Meanwhile, short rates increased dramatically in Q1 as investors significantly scaled back expectations for rate cuts. Yet, despite the aggressive re-rating at the front end of developed market yield curves, the increase in long-term rates was comparatively mild, giving back just a fraction of the Q4 2023 rally.
The muted reaction in longer yields suggests investors remain committed to the idea of locking in yield for the long term, and inverted yield curves show that they are willing to give up a bit of yield in order to do so. Despite the dramatic reassessment of potential rate cuts, end-users’ strong demand for yield broadly drove spreads 10 per cent tighter this year.
Too much cash?
In general, the strong bond inflows and the sharp rally in higher-risk fixed income have not happened in a vacuum. Instead, they occurred against a backdrop of rallying prices for a range of asset classes, from gold to cryptocurrency to AI stocks. While one can make the case for any of these bullish stories, perhaps there is a powerful contributing factor: Investors have too much cash.
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Some of the buoyancy in assets ranging from stocks, bonds and gold to cryptocurrency may be from investors paring back uncomfortably high cash levels. Based on the ratio of US money market assets to nominal gross domestic product, 21 per cent is historically high, and long bull markets in credit products have started in the past with similarly elevated ratios.
In absolute terms, money market fund assets soared during the pandemic. They surged again as savers at first sought safety, and then higher yields following the Silicon Valley Bank blowup. Compared to the roughly 15 per cent of nominal GDP invested in money funds during more placid times, the current level of 21 per cent is more akin to the highs of the 2002 and 2008 recessions – both of which were followed by strong, multi-year rallies in stocks and a generally favourable environment for credit products as well.
Support for bonds
While investor allocations to equities and real estate may have increased via appreciation, and cash allocations increased through flows, bond allocations may have been depressed by the rate increases over the past few years. This seeming imbalance in allocations – running counter to an ageing demographic – suggests that bonds could remain well supported if and as investors try to rebalance towards more normal or higher fixed-income allocations.
There are two broad categories of thought. One camp says: “Lower interest rates are coming; a soft landing is in the bag; AI will save the world; and do not bother me about geopolitical risk.” Stocks have nearly doubled from their pandemic lows, with half the rise occurring in practically a straight line over the last several months.
In the “hedge against geopolitical risk” category, gold has catapulted to new highs, up 25 per cent since early October, as tensions have risen in the Middle East. And, the Securities & Exchange Commission has unleashed a new pool of investor capital on the cryptocurrency market by enabling crypto exchange traded funds (ETFs). Over the last six months, the prehype and kick-off of the ETFs have driven a doubling of Bitcoin.
High yields generate return
Ever since the fall of 2022, when 10-year yields broke above 4 per cent for the US Treasuries, investor demand has suppressed long yields, causing an inversion of the yield curve as cash rates continued to rise. While many assumed this was a sign of a looming recession, alternatively, it may simply reflect investors’ recognition that yields are back at generational highs.
Since then, central bank rate cycles have peaked, adding a sense of urgency on the part of ageing investors, pension funds and financial institutions to get into the bond market at the peak of the rate cycle.
Looking ahead, the outlook for bond market returns over the long run remains strong. While we do not expect a decline in long-term yields, today’s still-generous yield levels will nonetheless continue to accrue.
Similarly, although wholesale spread tightening from current levels is unlikely, spread sectors can add incremental income and return as well as offer opportunities to add value through sector rotation and issue selection. One possibility is that the rally’s laggards would catch up, potentially resulting in spread compression across the quality spectrum.
In the higher-risk markets, such as high-yield and emerging markets, investors have finally turned their attention to the laggards: the lower-credit-quality realms. That leaves room to add value by playing for narrower spreads by quality, through tactics like a credit barbell, or issue selection in stressed/distressed credits.
All told, long-term rates and credit spreads are likely to remain relatively range-bound, with some potential for narrowing of credit spreads and favorable avenues for adding value through active management as the current high yields transform over time into realised returns.
The writer is chief investment strategist and head of global bonds, PGIM Fixed Income
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