- Global bond markets have endured a significant sell-off, as investors come to terms with interest rates staying higher for longer.
- European sovereigns are more favourably priced than US government bonds.
- We believe the pairing of long-duration with high-quality credit should serve investors well going forward.
After the Federal Reserve (Fed) indicated at its September meeting that it did not expect to cut rates until late 2024, bond markets fell sharply, with longer-duration US government bonds1 in particular enduring a substantial repricing.
Yields, which move opposite to bond prices, have risen significantly, with the yield on 10-year US Treasuries pushing above 5% in October – its highest level in 16 years2. 10- and 30-year US Treasury yields have increased by 66 basis points (bps) and 70 bps, respectively, since the start of September3, and we expect this volatility to continue.
Government bonds: Shifting expectations fuelling sell-off
Back at the beginning of 2023, when central banks were aggressively raising rates, the consensus view in markets was that developed economies would be in recession by the second half of the year. In the US, the downward-sloping inverted yield curve reflected this expectation, with longer-dated Treasuries yielding less than shorter-term government bonds in anticipation of a slowdown.
Yet by the start of the summer, it was clear that the largest economies, including the US, UK and euro area, were proving far more resilient than anticipated, especially in the US, where growth and inflation have remained persistently above expectations. The ongoing pressure on inflation, along with growing fiscal concerns about the ballooning US deficit, helped fuel the Fed’s recent higher-for-longer shift in sentiment that triggered the sell-off in Treasuries.
For bond investors, the good news is that US government bonds now look much more attractive, with longer-dated Treasuries offering a favourable risk/reward balance and yields of around 5% or higher. We see opportunity here to extend duration, particularly given the elevated recessionary risk outlook in 2024. At these higher yield levels, bonds offer sound portfolio ballast, as well as a hedge against more adverse risk and economic outcomes.
It’s a slightly different story in the euro area, where the latest data show the economy contracted in the third quarter. Vanguard’s economists expect a second consecutive contraction in the fourth quarter, which would qualify as an economic recession. The European Central Bank is likely finished with its rate hiking cycle, which has, historically, been a favourable time to add duration in active bond portfolios.
We’ve already seen European sovereign bonds outperforming their US equivalents4 and we believe this could continue – unless growth in the US begins to slow or European growth begins to strengthen.
Looking ahead, we remain selective when it comes to European government bonds and prefer to hold exposure to markets such as Spain, where the technical backdrop is more favourable and lower issuance is expected compared with other European sovereign issuers such as Italy. We also favour government bonds issued by Greece, where the consensus view is the country will likely regain its investment-grade status with rating agencies Fitch and Moody’s, sparking a tightening in Greek government bond spreads relative to Bunds and a relative outperformance versus other European sovereign bonds.
In the UK, it’s been a rocky year for government bond investors. Gilts have significantly underperformed their European peers5, with spread margins between gilts and Bunds reaching as high as 200 bps - the widest level since the early 1990s6. However, the Bank of England’s (BOE’s) June rate hike of 50 bps marked a turning point, both in terms of slowing down growth and dampening inflation, but also reinforcing the BOE’s credibility in fighting inflation. Since then, the gilt market has improved; if inflation continues to move lower, we believe gilts could continue to outperform7.
Credit markets: Banking on a soft landing
Similar to government bond markets, global credit markets have spent much of this year trying to price in a potential recession, as corporate bond performance would be heavily driven by the impact that a slowdown in growth would have on corporate fundamentals.
In a soft-landing scenario, in which the economy avoids a recession, policymakers would likely cut rates and we would expect the economic cycle to be extended. For credit investors, this would likely be a favourable outcome, providing attractive returns; and we’d expect US corporate spreads to tighten 25-30 bps from current levels, providing approximately 300 bps of excess returns compared with equivalent Treasury securities8. With credit spreads wider in Europe, we’d expect even higher levels of excess returns versus government bonds in a soft-landing scenario.
In a hard-landing scenario, we’d expect corporate spreads to widen 75-100 bps from current levels. In the US, this could mean spreads break above 200 bps – which may sound high to many investors but are actually quite reasonable when compared with other recessionary periods like the Great Financial Crisis, when corporate spreads widened by several hundreds of basis points amid a significant dislocation in markets.
We believe the UK, US and euro area are likely to enter recessions in the coming year – in which case, the pairing of long-duration with high-quality credit will, in our view, serve corporate bond portfolios well, with investment-grade bonds providing protection if recessionary conditions last longer, or are deeper, than expected.
We favour high-quality European corporates over US corporates because of their more attractive value proposition, in our view. As central banks approach the end of their tightening cycles, we expect European credit spreads, currently in the 70th percentile of their historical averages, to outperform US spreads which are in the 50th percentile9.
Positioning for volatility
Looking ahead, we expect volatility to remain elevated as the macroeconomic climate continues to shift. We believe active bond strategies that can offer attractive risk-adjusted returns by focusing on diversified, bottom-up security selection, will be well-positioned to navigate these uncertain market conditions - lowering the risk of large market drawdowns and providing more consistent returns for long-term investors.
Notes
1 Duration refers to a bond’s sensitivity to changes in interest rates; generally speaking, the longer the duration of a bond the more sensitive its price to interest rate changes.
2 Source: Bloomberg. Prior to October 2023, the last time the 10-year US Treasury yield was above 5% was in April 2007.
3 Source: Bloomberg; for the period 31 August 2023 to 31 October 2023.
4 Source: Bloomberg and Vanguard. Based on the returns of the Bloomberg Pan-European Total Return index and the Bloomberg US Aggregate Total Treasury index, for the period 31 December 2022 to 31 October 2023.
5 Source: Bloomberg and Vanguard. Based on the returns of the Bloomberg Pan-European Total Return index and the Bloomberg Sterling Gilts Total Return Value index, for the period 31 December 2022 to 31 October 2023.
6 Source: Vanguard.
7 Source: Vanguard.
8 Source: Vanguard.
9 Source: Vanguard.
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Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.
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