Let bonds carry you in 2024

THIS year is looking to be a year of gradual recovery for bond markets. In the first six months, performances across most major markets were largely positive, helped by the narrowing of credit spreads, which has offset the drag from higher treasury yields around the world.

Global macro data remained resilient in H1 2024, illuminating a soft-landing outcome that has supported investors’ confidence in credit markets. At the same time, juicy yields in a higher-for-longer rates backdrop continue to lure investors to credit markets. Helped by strong investor demand, credit spreads were compressed in the past six months, fuelling the returns of major bond markets.

As we enter the second half of 2024, we expect the backdrop to remain supportive for bond markets. While valuations have tightened across major markets, we continue to see pockets of opportunities, mainly across short-duration and higher-quality bonds.

The investment case for short-duration bonds remains compelling to us. With yields near decade-highs, we think such bonds continue to provide strong forward returns. We expect major treasury curves to remain largely inverted in H2 2024; consequently, yields of shorter duration are set to remain elevated. This is anchored by our core view that there would be no Federal Reserve rate cuts in H2 2024, and slow, measured cuts from the central banks, which have begun their cutting cycle.

At the same time, we see little potential for capital upside for longer-duration bonds, as we expect little room for longer-tenor treasury yields to dip in the absence of major central bank rate cuts in H2 2024, and taking into account sticky inflation and a resilient global growth backdrop.

Furthermore, we think the potential for price volatility is not yet over for longer-duration bonds. If Fed rate cuts for 2024 are pushed back, like what we saw in the first half of the year, we anticipate upward pressure on longer-end treasury yields.

Generally, we think finding the right window to time the Fed rate cut is a tricky affair, given a probable bumpy descent and unpredictability in US inflation data. Extending duration too early may invite unwanted price volatility if markets keep repricing the timeline for rate cuts. Currently, we are comfortable holding on to shorter duration bonds, which can provide comparable yields or a higher yield pickup to longer-tenor bonds of similar credit quality.

Favouring quality bonds

We also favour stronger-quality bonds. Since the steep global rate hikes, the cost of borrowing for companies has risen significantly, which has exerted greater financial stress on both investment-grade and high-yield issuers. However, as rates stay higher for longer, we expect high-yield issuers to exhibit greater vulnerabilities, given weaker fundamentals and credit metrics.

For high-yield issuers, the amount of maturing debt is also expected to climb over the next two years. With a significant portion of debt maturing as soon as 2025, we see risks of financial stress when the principal repayment on high-yield debt draws near, and when issuers refinance, likely at a much higher cost than before.

S&P Global has estimated that BB-rated US issuers may see a 2.4 per cent increase in yields for bonds maturing in 2024, up from a median coupon of 4.4 per cent. BB-rated European issuers face a larger 3.4 per cent increase, up from the median coupon of 3 per cent.

Default rates for global high-yield bonds have risen against a backdrop of higher benchmark rates as the trailing 12-month default rate has risen from a low of 1.4 per cent (pre-rate hikes) to around 3.9 per cent (end-Q1 2024), which is above the historical average.

To be clear, we are not expecting a wave of default events, given the supportive global economic backdrop and resilient corporate earnings. We are, however, expecting increasing pockets of risk for high-yield issuers down the road.

This is a concern for us as credit spreads for high-yield bonds have compressed drastically. From a valuation standpoint, we think high-yield bonds are expensive on aggregate, and bond investors are under-compensated for the risk they take. We also view this as a sign of heightened market optimism, which we think is overdone considering the underlying risks for riskier issuers.

In contrast, we expect high-quality issuers to remain resilient in a higher-for-longer rate environment. Relative to high-yield bonds, we think global investment-grade bonds are attractive, given strong credit metrics and elevated yields relative to history, supported by higher benchmark rates. With the narrowing of credit spreads, the yield pickup of high-yield bonds over their investment grade-counterpart has also declined, giving investors less incentive to hold on to riskier bonds.

As we look back, we see 2022 and 2023 as a big reset for the bond universe as markets digest the steep global rate hikes and macro changes. Having crossed that hurdle, we think the worst for bond markets is behind us, and we remain optimistic about the road ahead.

The writer is a portfolio manager at the Bondsupermart Team, iFast Financial, the Singapore subsidiary of iFast Corporation