Julien Eberhardt, Fund Manager, in the Invesco Fixed Income Europe team shares his thoughts on the key headwinds that have impacted bond market performance in 2024.
Find out why he is more positive on rates in Europe than the US and in cautious on credit risk and how this is influencing his management of the Invesco Euro Corporate Bond Fund in our Q&A.
I think you have to start with interest rates. We’ve been paying a lot of attention to duration and the central banks. Government yields have been moving in a fairly wide range, just like last year. Within this volatile environment, the overall direction has been to higher rates. The markets have moved from pricing in six cuts from the Fed in 2024 to suggesting there might not even be one. Things have been a bit more stable in the EUR rates market, but we’ve still gone from expectations of about 150bps of cuts to just 50bps.
I think it’s reasonable to see the ECB cutting ahead of the Fed, even though it hasn’t happened often before. The macro background makes it easier for the ECB. Growth is slower, so they have more justification for cutting, and lower forecast inflation gives them room. The market is pricing an initial cut in the coming weeks.
I’m broadly happy to hold duration at this level. If rates stay as they are, the yield is okay. If expectations for cuts increase, we’ll benefit from capital return.¹ The modified duration of the Euro Corporate Bond Fund is 5.3, which is a bit above the market (the ICE BofA Euro Corporate Index is 4.5).
I have very little USD duration in the portfolio. Growth has really held up and the ongoing impact of the fiscal stimulus creates a risk that inflation is stickier. So, I’m more positive on rates in Europe. But it’s important to remember that there’s a difference between not holding USD duration and the Treasury market not influencing your portfolio. The Treasury market is always important. If there is a big move in Treasuries, Bunds will move too.
I’m happy with the yield in the credit market, and there are individual bond ideas that I like, but it’s hard to say that these are attractive market levels to be adding to credit risk. Spreads have tightened a lot. I’m very conscious that the yield is weighted more to rates than to spreads. I am thinking more about being careful and avoiding problems. I’m worried that we may be at the beginning of a period of stress in credit. Economic conditions have been better than expected but a less positive consequence of that is rates staying higher for longer. That’s a headwind for corporates re-financing debt. 2
My aim in the Euro Corporate Bond Fund is to deliver a good return and a good risk-adjusted return through active management.3 We have some flexibility in the mandate, but the core asset class is investment grade corporate bonds. As I’ve become cautious on the valuation of credit more widely, I’ve been adding a little cash and higher quality issuers with higher credit ratings, gradually reducing exposure to the riskier parts of the market.
There are short-dated corporate bonds in the portfolio, alongside some cash. This reduces volatility and I’m still getting a reasonable yield. The short-dated bonds are mostly very low credit risk names, in my opinion, and they are yielding 4.4% (helped by higher short-term rates), which I think is okay.
I’ve also added to senior bank paper. My allocation there is about as high as it has ever been. That’s a valuation call. I get a little less yield on the seniors but I believe the reduced risk from being so high up the capital structure, along with the quality of the names I’m holding, makes it an attractive option on a reward to risk basis.
No, I’m quite positive about the banks. The sector is in good shape. I’ve just been improving the quality of my allocation. I’ve cut a couple of percent from AT1s, which has brought the total allocation to subordinated banks down to 13%. I probably cut too early. But banks are sensitive to growth, and I also want to have some room to add if there is a dip.
One feature of bank name selection is that we have been reducing exposure to German names. We tend to favour big banks with diversified businesses, whose balance sheets are less likely to be stressed by weakness in one part of the economy. Some of the smaller German banks are a bit more heavily exposed to the real estate market. We aren’t holding any of them, but we are also wary of possible knock-on effects in larger German banks if they come under strain. I would class this more as a risk management strategy than a strong view on the individual credits.
We have a little less than 2%, but you are right – it could be zero.
The first thing I would say is that I am comfortable with the high yield exposure that we have. They are good quality names, mostly with quite short maturity. I’m happy to hold them until they mature.
I’d also make a broader point. We take account of external credit ratings and we are very keen to learn from the work that the rating agencies do, but we are not slaves to ratings. We are, first and foremost, bond selectors and we give ourselves the flexibility to go outside the investment grade universe.
You can see the primacy of bond selection in our approach in another way. We are wary of real estate, as a sector. I’ve mentioned our positioning on German banks. But we have added some property names over the past couple of quarters, based on our fundamental credit work. They are a mixture of names, some from parts of the sector that we think are stronger, like warehousing, and some more diversified names that have been weak and are now attractive on a valuation basis. I wouldn’t say that we have any of the riskier names in the sector, but we are happy to be involved where we can find opportunities.
Before talking about when I would spend it, I should point out that the opportunity cost of holding liquidity is lower now. Even the outright cash in the portfolio is earning 3.5%.
I could see two scenarios that might make a more risk-on stance attractive. The first is if a continuation of strong growth in the US makes inflation look more sticky. We could see a (further) re-appraisal of the path of US interest rates and a widening in spreads as the market begins to lose faith in the ‘soft-landing narrative’. Alternatively, if growth starts to disappoint, markets may start to worry that the central banks have fallen behind the curve, that US fiscal stimulus has been a bigger part of the growth story and that the economy is heading for a cliff edge. That could be good for rates but very negative for spreads.
In this environment I am comfortable taking the reasonable level of yield that is available in the market and practicing a bit of caution on credit risk. Overall, following the rate hikes, we are in a good environment for bonds. But I think there might be better opportunities to extend risk.
Julien Eberhardt is co-fund manager of the Invesco Euro Corporate Bond Fund, which he has managed since 2016, supported by the rest of the Invesco Fixed Income team.
The fund invests in a diversified portfolio of primarily investment grade bonds, denominated in Euros and is without benchmark or duration constraints, meaning it’s free to adapt to changing market conditions. Click below to learn more.
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1 Please note there is no guarantee this performance target will be achieved
2 Views and opinions are based on current market conditions and are subject to change.
3 Please note there is no guarantee this performance target will be achieved.
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
Invesco Euro Corporate Bond Fund
Debt instruments are exposed to credit risk which is the ability of the borrower to repay the interest and capital on the redemption date. Changes in interest rates will result in fluctuations in the value of the fund. The fund uses derivatives (complex instruments) for investment purposes, which may result in the fund being significantly leveraged and may result in large fluctuations in the value of the fund. The fund may invest in distressed securities which carry a significant risk of capital loss. The fund may invest in contingent convertible bonds which may result in significant risk of capital loss based on certain trigger events.
Data as at 31/05/2024 unless stated otherwise. Views and opinions are based on current market conditions and are subject to change.
This is marketing material and not financial advice. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. Not all share classes of this fund may be available for public sale in all jurisdictions and not all share classes are the same nor do they necessarily suit every investor.
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