• Potential interest rate cuts by central banks in Europe could boost bond prices – leading to more favourable return outlooks for existing bond investors.
• With a divergence between European policymakers and the US Federal Reserve looking more likely, investors should brace for heightened volatility in bond markets in the months ahead.
• Compared to government bonds, credit markets have been relatively stable this year, with credit spreads tightening to near-historically low levels.

In this Q&A, our fixed income experts examine what may lie ahead for global government bond and credit markets and what it could mean for client portfolios.

For fixed income investors, 2024 hasn’t panned out quite as expected. At the start of the year, bond markets were primed for aggressive policy cuts by major central banks amid slowing inflation and growth. Instead, stronger-than-expected growth and inflation reports in the US have led the US Federal Reserve (Fed) to push back any potential rate-cutting plans – marking a divergence with policymakers in Europe, who are likely to begin cutting rates over the next few months. 

Here, Vanguard’s fixed income experts share their views on how they’re navigating changes in interest rate expectations, policy divergence and other issues that are top-of-mind for bond investors in the current environment.

Q: Is the economic divergence between Europe and the US meaningful for fixed income investors?

Ales Koutny, Head of International Rates, Vanguard Europe:

The divergence between the economies of Europe and the US is driven by differences in growth and inflation rates in the two regions. In Europe, economic activity has been weak and the disinflation process has been ongoing for several quarters; as a result, the European Central Bank (ECB) and the Bank of England (BoE) are likely to begin cutting interest rates in the near future – unlike the Fed, which is unlikely to cut rates before the end of 2024, in our view.

In the US, a string of stronger-than-expected growth numbers and re-accelerating inflation reports have led bond markets to lose confidence in the disinflationary trends from 2023 continuing – causing a significant repricing in US government bonds since the start of the year.

While the chances of a rate cut by the Fed are unlikely before the close of 2024, we can’t entirely rule it out, if inflation and growth align favourably. On the other hand, if positive surprises in growth and inflation persist, there’s an outside chance the Fed could wind up hiking rates, although this would likely heighten the risk of recession, which would trigger rate cuts. If the ECB (and the BoE thereafter) cuts rates, it could materially alter the return outlooks for existing bondholders through more favourable returns, as lower rates generally support rising bond prices.

Q: With so much uncertainty ahead, how should investors be positioning their fixed income portfolios?

Kelly Gemmell, Head of Fixed Income Product Specialism, Vanguard Europe:

Any unexpected changes in monetary policy are likely to impact bond markets, and investors should brace for further volatility in the months ahead. 

One of the roles of bonds is to act as a stabiliser in client portfolios ­­– and at current yield levels, this is especially the case. Today’s bond yields provide healthy levels of income that can help absorb at least some of the future volatility in bond prices. For example, the Bloomberg Global Aggregate Credit Index is currently yielding close to 5%, which means interest rate expectations would need to rise more than 0.75% from current levels before we’d expect to start seeing negative returns¹.

Q: What’s Vanguard’s outlook for credit markets?

Sarang Kulkarni, Lead Portfolio Manager for Investment-Grade Credit, Vanguard Europe:

So far this year, global credit markets have been relatively stable compared with government bond markets. In Europe, credit spreads are wider than in the US but the gap is narrowing, reflecting investor optimism and recent ratings upgrades of several issuers from high-yield to investment-grade.

Despite the heightened uncertainty, for credit investors, it’s not like the volatility we experienced in 2022. Back then, credit spreads were widening, amplifying losses for credit investors. Today, credit spreads are tightening and trading below their historical averages, which has boosted returns for credit investors.

It’s worth noting that tight credit spreads don't need to keep tightening for corporate bonds to outperform. As long as spreads remain within a range, credit can still deliver excess returns relative to government bonds, provided they are supported by a stable macroeconomic backdrop. Historically, credit investors have fared well in similar conditions. During the period from 2004 to 2007, which was relatively stable in terms of growth, inflation and interest rates, credit spreads were trading at even tighter levels than today², and delivered positive excess returns for credit investors over the three-year timeframe³.

Q: Do higher yields present any challenges for fixed income investors?

Kelly: While higher yields generally improve outcomes for bond investors, they also increase the attractiveness of cash, which can offer a comparable yield to bonds over the short-term. However, for long-term investors, bonds are likely to offer more attractive long-term returns as well as diversification benefits - which can help absorb equity volatility when markets are shifting. Cash won’t do that. If policymakers cut rates, bond investors will benefit from a rise in existing bond prices; whereas investors who parked their savings in cash would miss out on this upside while also seeing the rates on their cash accounts fall. 

Q: How can investors manage currency risk in the current market climate? 

Kelly: Given the potential volatility in currency markets, especially with the expected monetary policy divergence, we advise hedging currency exposure in clients’ fixed income portfolios. Hedging can significantly reduce the volatility associated with currency fluctuations, allowing fixed income investments to perform more predictably for investors.

Q: Finally, which fixed income strategies do you recommend in the current market environment?

Sarang: Investors should avoid trying to time the market and focus on diversifying their fixed income portfolios to mitigate risk.

Kelly: In times of uncertainty, active fixed income strategies can especially add value for investors. By capitalising on the volatility in fixed income markets, active managers can take advantage of market dislocation opportunities while mitigating exposure to downside risk – resulting in potentially higher risk-adjusted returns for the same level of risk.

Of course, choosing the right active fixed income manager is key. Investors should look for a manager who emphasises the value of risk management in their investment process. Risk control has always been an important facet of active management, but even more so in times of uncertainty.

Additionally, investors should look for a manager that has a consistent track record of delivering alpha over time in multiple market environments by making the most of relative value opportunities, rather than taking top-down, directional bets that often mirror market movements – which can lead to big losses in times of volatility.

This article is based on our ‘What lies ahead for bond investors?’ webinar. You can watch the full webinar on demand here. 

¹ Source: Vanguard and Bloomberg, as at 31 May 2024. Based on the Bloomberg Global Aggregate Credit Total Return Index (Hedged USD).

² Source: Bloomberg and Vanguard. In 2004-2007, investment-grade credit spreads averaged around 0.7%; versus 0.9%-1.0% in the current market. Based on the option-adjusted spreads of the Bloomberg Global Aggregate Corporate Index (Hedged USD), for the periods 1 January 2004 to 1 January 2007 and 1 January 2024 to 31 March 2024.

³ Source: Vanguard and Bloomberg. Based on Bloomberg Global Aggregate Corporate Index (Hedged USD) for the period 1 January 2004 to 1 January 2007.

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Past performance is not a reliable indicator of future results.

Some funds invest in emerging markets which can be more volatile than more established markets. As a result the value of your investment may rise or fall.

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.

Reference in this document to specific securities should not be construed as a recommendation to buy or sell these securities, but is included for the purposes of illustration only.

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