Fixed income investors should not get greedy in a market where inflation could continue to surprise to the upside and risks assets remain unmoved by major changes in the outlook for interest rates, according to AXA Investment Managers’ Nicolas Trindade.
Trindade, who manages a range of short duration strategies for AXA IM, says that while sovereign bonds yields, particularly in the US, have repriced significantly higher this year as the market has continued to absorb sticky inflation data, credit spreads remain tight overall, leaving investors with very limited compensation in some sectors for taking the additional credit risk.
“Treasury yields are 50 basis points higher on a year-to-date basis and the market has gone from expecting six interest rate cuts from the US Federal Reserve (Fed) at the end of 2023 to two,” he says. “So, it is amazing to me that risk assets have barely reacted at all. Credit spreads tightened substantially at the end of last year because the market thought the Fed would cut a lot. Now no-one thinks the Fed will do that, but credit spreads haven’t really widened to reflect that significant change of view.”
Trindade says the current situation reminds him of late 2021, when credit spreads were also tight, and the market and the Fed failed to react to continued upside surprises to inflation as it was assumed to be transitory before the painful realization that it was a much more persistent threat.
“If you look at the first quarter for US CPI it does not look pretty as it annualizes at above 4% and that is just not OK for the Fed.” he says. “The risk – the thing that will finally break the market – is that the Fed opens the door to interest rate hikes. That is not our central scenario, but investors must have it at the back of their minds.”
In this environment, Trindade says investors should tread carefully, and avoid taking unnecessary risk in the pursuit of higher yields.
“Investors should not get greedy in an environment like this,” he says. “Yields have come right back up after the sell-off, so you don’t need to take big risks to get a good return. We favour investment grade bonds where fundamentals remain solid and the default risk is much lower to capture attractive yield opportunities. With uncertainties remaining elevated, we are cautious on high yield and emerging markets at these valuations.”
He also prefers eurozone and sterling bonds for duration exposure, due to his belief that the central banks in both regions will cut interest rates ahead of the Fed, if it cuts at all. But he also has a large overweight in short-dated Treasury Inflation-Protected Securities (TIPS) as protection against further inflation surprises in the US.
“Short-dated bonds are generally just really attractive right now from a yield perspective, and because sovereign yield curves are inverted there remains no incentive to buy longer bonds, more duration risk for less yield” he says.
“If inflation continues to surprise to the upside, particularly in the US, investors will get better protection from short-dated paper. Investment grade bonds at the front of the curve offer a nice combination of better yields, less duration and solid fundamentals.”
