Fixed income: several factors urge caution

By Gael Fichan, head of fixed income, Syz Bank 

We maintain a neutral position on fixed income within our portfolios, guided by a mix of encouraging inflation data, a cooling job market, and the onset of the Federal Reserve’s rate cut cycle.

While these positive indicators provide some optimism, several factors urge caution. Ongoing supply pressures driven by the need to finance the large fiscal deficit, a flat yield curve, and persistent interest rate volatility suggest it is premature to adopt a more bullish stance. Additionally, while our base case remains a soft landing, the potential for significant long-term interest rate declines is limited.

In this context, we continue to favour the short and intermediate segments of the yield curve over long-duration bonds. We remain cautious on high yield and hold a neutral position on investment grade credit. Valuations in the high yield space are particularly stretched—especially compared to investment grade credit—given where we are in the economic cycle. Furthermore, with potential volatility expected in the second half of 2024, we are also cautious on USD-denominated emerging market debt. However, EM local debt could present opportunities if the US dollar continues to weaken.

Government Bonds

Our outlook for government bonds with maturities under 10 years remains positive, as we anticipate favourable conditions for yield improvements by year-end. This view is supported by several key factors:

• Reassuring inflation data and economic stability: The US economy shows signs of normalisation, with a cooling job market and gradually declining inflation rates, despite occasional volatility.
• Monetary policies: Federal Reserve Chair Powell has initiated the rate cut cycle, which is expected to continue. In addition, easing quantitative tightening and improving liquidity in the Treasury bond market through a buyback program are expected to further stimulate demand.
• Bonds as a diversifier: Bonds are once again proving their worth as effective diversifiers in balanced portfolios, with their correlation to equities turning negative.

However, we remain cautious on longer-term bonds due to the flat yield curve, negative term premiums, ongoing rate volatility, and the pace of interest rate declines. Other concerns include the growing US fiscal deficit and increased Treasury issuance.

In Europe, we maintain a neutral stance as the European Central Bank initiates monetary policy normalisation, beginning with its first rate cut in June and in September. We anticipate additional rate cuts in October and December, which could support a bull steepening of European rates. The market has largely priced in the French election outcomes as a contained, idiosyncratic risk, with the yield spread between 10-year Italian and German bonds returning to pre-election levels of 130bps. 

However, the bond market still perceives some risk, as the 10-year French real yield is near its highest level this cycle. While European wages remain a concern, the latest wage report shows promising progress, and ECB members are confident of further normalisation soon. Our outlook on UK government bonds is also neutral but close to turning positive. The political shift following Labour’s victory has not significantly impacted the gilt market, with memories of the 2022 crisis under Liz Truss fostering caution towards expansive fiscal policies.

Corporate Bonds

Our stance on investment-grade bonds remains neutral. Credit spreads have tightened significantly to their lowest levels since 2021, reducing the safety margin to just 15% of the total yield. Current market conditions are “priced to perfection,” necessitating close monitoring. For the first time since 2022, there are more BBB-rated bonds with a negative outlook than those with a positive outlook. Despite these factors, the solid macroeconomic backdrop and concerns over US Treasury sustainability suggest that it might be premature to reduce credit exposure. In the high-yield sector, we see selective opportunities in short-term corporate high-yield bonds due to their favourable risk/reward profile, though we acknowledge that overall valuations in high yield are stretched, especially if volatility increases in the second half of 2024.

Emerging Markets

Our stance on hard-currency EM debt remains cautiously negative, though we identify some attractive opportunities in bonds with maturities up to four years. Market sentiment toward EM debt remains subdued, as evidenced by ongoing negative capital flows and rising short interest in USD-denominated EM debt. Valuations appear stretched, with EM corporate spreads at their narrowest since 2007. However, the recent weakening of the US dollar and declining US real interest rates have provided some relief to EM local debt, making it an attractive consideration if the trend continues.