In our view, the neutral rate, or level of real interest rates at which central bank policy is neither stimulating nor restricting economic growth, has shifted upwards. Bond yields have risen to reflect this new reality, and we believe higher yields create a positively skewed, asymmetric return profile for fixed income investment. If we are wrong, and the neutral rate has not changed, yields could decline sharply as inflation is brought under control – potentially generating significant gains for fixed-income investors.
Source: Bloomberg US Aggregate Index. Data as at 31 October 2023.
Nominal US bond yields have risen sharply
global rates
globaL inflation
Multi-asset
investment grade credit
US municipal bonds
High yield credit
Secured finance
Currency
Source: Insight and Bloomberg. Data as at 31 October 2023. Inflation forecasts are for Consumer Price Inflation.
Food and energy prices have stopped falling
Inflation moderated in 2023, driven by the powerful statistical impact of base effects as food and energy price spikes following the Russian invasion of Ukraine dropped out of the year-on-year data. We believe 2024 should bring greater clarity on where the underlying rate of inflation is likely to settle – and at this stage, it appears likely to be above 2%. This is likely to create a dilemma for central banks as unemployment drifts upwards and calls for easier policy grow. Some may prove far more willing to adapt their policy frameworks to this new reality than investors currently believe, effectively allowing inflation to run at higher levels than in the past.
The characteristics of the current cycle are not out of line with what we’d typically expect at the end of a US hiking cycle. If we assume that this is a genuine cycle end, the period between the last rate hike and the first rate cut has generally been a rewarding one for both bond and equity investors. But, the rise in yields presents a valuation challenge to equities. For many years, very low rates created a ‘TINA’ (there is no alternative) narrative to owning equities. In 2024 that shifted to ‘TARA’ (the are realistic alternatives) and arguably we are now moving to TABA (there are better alternatives) to owning risky equities.
Source: Insight and Bloomberg. Data as at 31 October 2023.
Yields in investment grade credit are back above pre-global financial crisis averages
The yields available in investment grade credit have risen to levels comparable to those of the decade before the global financial crisis. In our view, this represents an opportunity to lock in attractive levels of income, but to really maximise returns we believe careful credit analysis will be key. There is the potential for significant divergence in corporate bond performance in the year ahead in an environment of slow growth and rising funding costs.
Source: Urban Institute, BAML; National Association of State Budget Officers (NASBO) Fiscal Survey of States, January 2023.
Municipal reserves have surged post-pandemic
For those investors seeking to take advantage of the yields available in corporate credit, we believe taxable municipal bonds are an asset class that are an overlooked opportunity that is systematically mispriced. Taxable munis offer similar yields to US corporates but have several advantages; many of these public corporations are virtual monopolies, funding projects such as schools and hospitals and delivering services with inelastic demand to the public. The nature of these revenues, combined with high levels of reserves, means the asset class has previously been more resilient to periods of sub-trend growth and has historically experienced extremely low default rates.
Source: Insight and Bloomberg. Bloomberg US High Yield Index. Data as at 31 October 2023.
Yields have moved sharply higher
For the first time in many years high yield is living up to its name, with high yield offering very high levels of income at a time when defaults are expected to remain contained. In the US high yield market, yields are now so high that they offer returns in excess of average long-term rolling 12-month returns on the S&P 500 Index. As long as defaults remain low as we expect, this offers an opportunity to contractually lock in returns normally associated with equity market investment in an asset class which has historically experienced significantly lower drawdown risk.
Source: Insight and Bloomberg. Data as at 31 October 2023.
Yields have moved sharply higher along with short-term interest rates
For investors that don’t want to migrate up the risk spectrum, the floating rate structure of most secured finance issues allows investors to take advantage of higher interest rates in very short maturities without the duration risk implicit in fixed-rate bonds. Perhaps the most important feature of all, however, is the powerful payment waterfall structures built into the asset class that make them fundamentally defensive. This makes the senior tranches of secured finance issuers well placed to withstand any economic weakness that may result from the policies implemented by central banks to slow growth and reduce inflationary pressures.
Source: Insight and Bloomberg. Data as at 31 October 2023. Inflation forecasts are for Consumer Price Inflation.
The US dollar remains very overvalued by historical standards
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The global economy is slowing, but the US economy is still expected to grow at a more rapid pace than other developed markets. This, combined with higher interest rates, makes it difficult to bet against the US dollar. However, after a bull run that’s lasted more than a decade, the US dollar sits close to historical highs, and an unsustainable fiscal position has created a vulnerability. This sets the scene for a choppy backdrop against which we feel a tactical approach is the best option.
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global rates
Source: Insight and Bloomberg, data between 1970 and 2023.
Long plateaus in the Fed rate are usually a constructive backdrop for equity and bond returns
Higher rates should mean higher long-term returns
Structurally higher inflation ahead
If rates have peaked, it’s normally constructive for asset prices
Yield is back – but careful analysis could help maximise returns
Time to add munis to the credit mix
The new growth asset
High income with the powerful defence of payment waterfalls
Hard to bet against the US dollar but stay tactical in 2024