In the second instalment of Investment Week's 'Higher for longer' series, examining the impact persistently higher interest rates are set to force on various corners of the market, we examine the effect this has had on the fixed income market.
This week, 10-year US Treasury yields surpassed 5% for the first time since before the Global Financial Crisis.
Malin Rosengren, portfolio manager at RBC BlueBay Asset Management, said that a higher for longer environment would force a transfer from low yielding assets into fixed income, as the increased yield of low-risk bonds becomes more appealing.
Bond sell-off fails to stifle fixed income flows while equities shed £1.6bn
Rosengren noted that supply side factors were now a key consideration in the current era of higher interest rates, with the increased costs of financing budget deficits pushing up the issuance of government bonds to the market.
This is expected to increase the global net supply (ex-Treasuries) 48% next year, with the US net Treasury supply to the public reaching all-time highs, she noted.
"This treasury supply will need to be absorbed - but it is a question of who will be the buyer," Rosengren said.
As central banks have moved to quantitative tightening and foreign demand diminishes as foreign investors "increasingly shift money back home", the domestic public will be the main buyers of government bonds, leaving them to determine the ‘appropriate level' for yields, she explained.
Developed markets
The argument against holding US Treasuries has become more difficult to defend, Nishan Maharaj, head of fixed interest at Coronation Fund Managers, said, pointing to their decade-high yields and the fact that term premiums in longer-dated Treasuries "are now closer to what one would consider fair".
Maharaj also noted that as higher absolute yields remain elevated, borrowing costs for corporates will also increase, leading highly leveraged corporates to begin "feeling the pressure".
As such, investors should consider that while outright levels on many corporate bonds might appear attractive, "more attention needs to be paid to the underlying financial health of these companies" to ensure credit spreads are commensurate with underlying risks.
Dave Breazzano, head of US high yield and portfolio manager at Polen Capital, said that most US high yield bond issuers were "well positioned to weather the storm", as the overall quality of the market has improved and the bulk of maturities have been extended.
"While higher coupons have begun to trickle into the high yield market, the transfer of higher rates to higher coupons for issuers more broadly will take time," he said.
However, the US leveraged loan market is set to face "more immediate pressure" from a shift to higher for longer, he warned.
"Given the floating rate nature of loans, we have already seen coupons on existing structures double," said Breazzano.
"As a result, loan issuers face higher interest burdens and greater challenges to free cash flow, potentially crimping their ability to de-lever ahead of a recession."
Appetite for bonds not abating in face of 'exaggerated' 5% Treasury yields
Niall O'Sullivan, CIO of multi asset strategies EMEA at Neuberger Berman, said the firm's fixed income team was "beginning to see some weakness in consumer-facing and industrial issuers", therefore favouring high quality companies in both investment grade and high yield.
The CIO said some areas of securitised credit "still offer attractive value", as total returns are likely to owe much more to coupons than capital appreciation.
However, the team has also become more positive on duration, between the two- and seven-year maturity points on yield curves, "where normalisation over recent weeks has made yields competitive with cash again".
Phil Milburn, co-head of the Liontrust global fixed income team, said the team had positioned its strategic portfolios at a long duration of eight years relative to its neutral level of four and a half years.
"However, we prefer short-dated and mid-dated government bonds and do not own any with a maturity of 15 years or longer," he added.
Emerging markets
Mary Therese Barton, CIO of fixed income at Pictet Asset Management, noted that as emerging economies are generally at a more advanced stage of the interest rate cycle, their growth is set to rest above developed markets.
In addition, as US growth slows, emerging market local debt "should benefit from a softening dollar and more robust local economies", she said.
Gilts claim spot in ii Q3 performance index as investors hunt for yields
However, Maharaj said that emerging market bonds will now be "fighting against" the highest developed market yields in over a decade, leading them to embed a high risk premium as a "buffer" to developed market bonds.
"This implies elevated yields are here to remain in EM until such time that the global monetary policy cycle turns," he said.
Lower-for-longer?
By contrast to most expectations, Claudia Fontanive-Wyss, portfolio manager at Vontobel, argued that central banks will begin cutting rates "quickly" next year, pointing to the expected shifts in real interest rates over the coming months.
She pointed to comments from New York Federal Reserve president John Williams, who said rates would have to be adjusted down to keep real interest rates constant.
Fontanive-Wyss argued that as central bankers in developed markets have "confirmed that the current policy stances are already sufficiently restrictive", and as credit conditions become more restrictive, interest rates will necessarily be cut.
"Credit conditions are also very restrictive at this stage, especially in the US, where interest rates on credit cards are at 22%, the highest level since 1995, while delinquency rates on consumer credit cards are nearly 8% compared to the lows around 5% pre-Covid," she noted.
"It is likely that this will lead central banks providing support rather than keeping rates restrictive for much longer."