Bond investors have had to deal with some tough love over the past year. When we pass along main indices, the YtD results tally as follows: European Government Bonds have retreated 14.64%, European IG corporate bonds have dropped 13.23%, European High Yield has resisted well, adjusting 11.85%. The European Aggregate universe has been damaged by 16.18%. The Global Aggregate index expressed in Euro has benefited from a strong USD allocation of about 44%, limiting the pain at 9.13%. The global EM government bond index has resisted best, backing off by 6.75%.
USD currency exposure next to HY and EM bond beta could have limited the drawdown. Seeking diversification benefits in higher volatility bond sectors pays off if one actively seeks to maximise exposure to independent risk factors. Over 2022, correlation has been positive between equity and fixed income asset classes. On an isolated level however, investors would have been able to seek beneficial negative correlation profiles.
At this juncture, markets have priced Fed Fund rates to peak around 5.00% over H1 2023 versus 3.00% for the ECB. If we zoom in on the FED path over 2023-2024, we notice that the delta between June 2023 and June 2024 3-month Eurodollar contracts imply 100bp of rate cuts over that horizon. Further out the Eurodollar strip, June 2025 till June 2027, one observes a stable 3-month rate around 3.5%. An interesting observation: might the long-term neutral 2.5% FED Fund rate shift higher? Anyway, stable 3-month rates around 3.5% imply 0.00% real short-term rates under stubborn inflation at 3.5%. A far cry from the 2.00% inflation mandate the FED aspires to.
Consensus economist estimates call for 2023 global real growth between 1.9% and 2.5%. Against historic yardsticks, that falls under a recessionary year. Next year’s EU and US real growth rates settle around 0.00%. If central banks seek higher terminal rates than priced in today, nasty recession probabilities will rise, and protracted negative outcomes will impact market valuations and rattle financial market stability. As mentioned, central bankers are well aware of such non-linear risky outcomes. That explains the increased divergence in governor messages. Some turn dovish, some remain hawkish.
Clearly, central banks might become less sensitive in lowering policy rates the moment the business cycle weakens. Proof is building that the transition path towards a carbon-neutral world is littered with question marks around supply uncertainty and lack of flexibility. The price of climate mitigation, and especially adaptation, will be high. The spending effort, capex ramp up has to settle between +30% to +50% by 2040 across key power, steel, cement, building and transport sectors. When the corporate sector maintains profit margins, CPI pressure is around each corner. That will make a return to 2.00% stable inflation a stretch. Hence, the question arises how to assess the current value on offer across rate markets? A key requirement in that exercise pushes us to have a look at forward rates.
In order to calculate the forward rates or break-even interest rates, you require the yields to maturity and the number of years left before the bonds mature. We will not go into the formulae but explain through a real-life example. You can invest in the current 5-year US Treasury bond yield at exactly 4.00% or a 10-Year US Treasury bond 3.83%. What maturity should you pick? That requires us to calculate at what 5-year rate in 5 years’ time you would turn indifferent between the two investment options.
This 5Y5Y break-even rate or forward rate sits at 3.60% today. So, investing at 4.00% today followed by investing at 3.60% in November 2027 for the next 5 years results in the same outcome as investing in 10-year at 3.83% today. However, if you believe that in 5 years’ time the 5-year rate will be below 3.60%, one should invest in 10-year UST today. The opposite, expecting a 5-year rate higher than 3.60% in November 2027 leads you to investments at 4.00% for 5 years today.
You notice that forward break-even rates are lower than the current spot rate when we are confronted with an inverted yield curve, as is the case in the US today. If the yield curve is positively sloping, the forward rates are higher than current spot rates. Same goes for US inflation swaps with 5Y5Y forwards at 2.50% versus 5-year zero-coupon swaps at 2.53% and 10-year zero-coupon swaps at 2.52%: a truly flat structure that calls for longer-term inflation (between 2027 and 2032) anchoring around 2.5%.
In Europe, we are faced with multiple options due to the fragmented Eurozone government bond market. The German yield curve is more or less flat. With the 5-year bund yield at 2.08% and the 10-year at 2.01%, the 5Y5Y forward or break-even rate sits at 2.07%. That makes for a difficult call. However, if we pick the Spanish yield curve, we get a nice positive slope today. With a 5-year yield at 2.50% and a 10-year yield at 3.00% we get a 5Y5Y forward or relatively high break-even rate at 3.52%. Effectively, a 3.00% 10-year yield attracts given a 5Y5Y Spanish forward rate almost at the level of the 5Y5Y US Treasury rate without undergoing any currency risk.
Bond markets have reached a stage where valuations provide for ample attractive real performance profiles. Profiles that consider slightly higher inflation paths across the US and the EU. With the 5Y5Y forward EUR inflation swap rate at 2.30% versus 2.50% in the US we observe that both track modestly above the long-term target of respective central banks.
Locking in spreads across IG, HY and EM bond sectors open the potential to generate excess returns. These excess returns have to be adjusted for higher volatility profiles. Under proper, active security selection, the risk profile can drop, thus enhancing excess returns.
Admittingly, current OECD government bond valuations have returned to acceptable levels that take into account modestly higher longer-term inflation scenarios….not average longer-term inflation paths beyond 3.00%. Investors need to reach out to higher credit and curve risk in order to seek protection against higher inflation scenarios.
