Why did bond yields spike in 2023? One explanation was an apparent supply and demand mismatch in government bond markets, particularly for US Treasuries.
With a considerable amount of US government spending already legislated for, the concern was that issuance of government debt would overwhelm bond demand now that the Federal Reserve is no longer buying Treasuries.
Bond vigilantes
At face value, this demand-supply mismatch has merit. Central banks absorbed a lot of the government debt issued in recent years and have committed to reducing their balance sheets. It is also true that in the absence of quantitative easing the bond market is ‘free’ to tell governments when it perceives spending programmes to be too much.
However, if private investors were worried about the uncontrollable profligacy of government spending, one might have expected the rise in yields to have been driven at least in part by higher inflation expectations.
Instead, the move through the summer of 2023 was almost entirely driven by real yields. The explanation for the move higher in bond yields that we find more compelling is that the US economy simply proved more resilient to higher interest rates than was previously expected.
Thus, the market has had to re-evaluate perceptions of what the sustainable or ‘neutral’ interest rate is.
Data in the driving seat
A combination of downside surprises on inflation and a softer tone from Federal Reserve officials pushed bond yields sharply lower in the last two months of 2023. The direction of yields from here will be driven by the economic data.
If inflation proves frustratingly stubborn above 2% and the economy remains resilient, then some of the rate cuts that are currently priced may have to be removed, which could put upward pressure on yields. If, however, the economy shows clearer signs of cracking under current policy rates,the pressure on central banks to cut rates will only intensify.
This could send bond yields lower and potentially release a sizeable capital gain – a 200bp decline in the 10-year US Treasury yield over the next 12 months would result in a total return of 20%.
In short, core bonds offer not only attractive income levels for investors but also potential capital gains in a recessionary scenario.
Being selective with fixed income
An element of selectivity will still be required. In Europe, we see the risk that some governments in the periphery will not be able to resist the temptation of expansionary fiscal policy in 2024.
The 10-year bond yield spread between Italy and Germany is below 200bps. As a result, we think higher quality core European sovereigns look more attractive than their peripheral counterparts.
Globally, investors will also probably favour sovereign bond markets where monetary policy prospects are the most favourable. While in the US and Europe, we – like many other investors – believe that policy rates have peaked, this is not the case in Japan.
With the Bank of Japan set to normalise policy further in 2024, upward pressure on long-term Japanese bond yields looks set to remain.
Refinancing needs warrants a step up in quality
In corporate bond markets, both investment grade and high yield bond spreads have held in well this year thanks to a combination of relatively resilient growth and relatively little refinancing.
The wall of refinancing to much higher interest rates is, however, coming. At face value it looks like 2024 maturities should be perfectly manageable, but corporates tend to look a year ahead when assessing capital needs, making the step up in maturities in 2025 a problem that will need to be addressed in 2024.
The situation is likely to be more problematic in high yield than it is in investment grade. While imminent maturities in high yield markets are not as large as investment grade counterparts, the gap between the current coupon and index yield is wider, suggesting a bigger jump in interest costs when corporates have to issue debt at higher rates.
This outlook leaves us with a preference for investment grade over high yield,where total returns could also benefit from higher rate sensitivity if government bond yields start to fall.
Active fixed income ETFs to strengthen portfolios
The opportunity to lock in yields at current levels looks compelling, even if bond volatility is likely to remain elevated.
This offers opportunities for active management and accordingly 56% of European ETF buyers surveyed in the recent ETF Pulse survey by ETF Stream and J.P. Morgan Asset Management think that 2024 will be the year for active management.
Whether you are seeking yield, total return or stability, J.P. Morgan Asset Management is the largest active UCITS ETF provider, offering active fixed income ETFs across the global aggregate, credit, green, social and sustainable, and ultra-short income bond markets.
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To read the full edition, click here.
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