As interest rates peak, here’s how we’re positioning

Julien Eberhardt and Lewis Aubrey-Johnson share their thoughts on some of the key themes in bond markets right now, and how these are influencing the management of the team’s euro corporate bond strategy.

The rise in inflation as the global economy emerged from the pandemic has had a huge impact on the bond market. Most of the shift higher in yields happened in 2022, but this year has also been challenging, with further rate hikes and high volatility. We think the environment now is positive for bonds and we are happy that we are being paid a good yield for the risks.

Duration has been the main driver in this period. The yield of the bund index rose from -0.5% in December 2021 to +2.5% at the end of 2022. This meant a negative return of nearly 18% for holders, but it also created a much better entry point. We increased the strategy's duration over the course of 2022 as yields rose, and we have increased it more since.

This more bullish positioning is not just based on higher yields. We think that the macroeconomic environment supports interest rate-sensitive assets.
 

Our outlook for inflation and interest rates

Rate hikes have consequences – and we are now starting to see these in the economic data. Inflation remains high but it is falling. Credit conditions and economic sentiment are weaker. Furthermore, the labour market is cooling. All these factors suggest that we are moving to the peak of the interest rate cycle.

At this point in the cycle, we should be more comfortable with rate risk – and we are. These factors also suggest that investors should be more wary of credit risk, as weaker conditions bite on earnings at the same time as higher borrowing costs are hitting the bottom line.
 

Adding duration and increasing credit quality

For illustrative purposes, let’s take a closer look at one of the strategy’s portfolios.

Since the start of 2022, we have moved from holding 25% less duration than the euro investment grade market to holding 15% more. Although longer-dated bond yields are lower than shorter-dated, we have been happy to hold these to lock in yields and potentially profit more from falling interest rate expectations.

We have also increased the quality of the portfolio, adding to core investment grade holdings and cutting exposure to higher credit risk names.
 

Markets are pricing in higher rates for longer – but we remain happy with our positioning

The scenario of the tighter monetary environment pushing down inflation and rate expectations has been challenged in the last few months. Economic data has been stronger than expected, particularly in the US. Furthermore, oil prices have moved higher. This has pushed bond yields to price in a slightly different outlook – one where higher inflation prompts central banks to keep rates high for longer, and higher growth gives them the opportunity to do so. As a result, longer-dated bond yields have risen more, which has hit the returns for a strategy like ours.

Despite this, we remain happy with our positioning. These recent moves have been a reminder that it takes time for interest rate changes to have their effect.
 

The US economy has been resilient, but pain could lie ahead

The US economy has indeed been resilient. And there are a few key reasons for this. The savings built up in 2020 have cushioned consumption and the labour market has remained strong. While rates for new mortgages are high, the effective rate on the total book of mortgages is only just starting to rise.

But those excess savings have been shrinking since 2021 and job growth is slowing. Not only are mortgage rates now climbing, but there are early signs of stress in rising bankruptcies and auto and credit card debt delinquency levels. All of this will put pressure on consumer sentiment which, in turn, should push down inflation, helping the central banks to meet their objectives.
 

Positioning for a range of interest rate scenarios

We remain convinced that this is a good time to hold fixed income.

In our opinion, we are close to the top of the rate cycle and we are being paid a good yield on our bonds. If rate expectations fall, the duration of our portfolio means we will gain from price appreciation. But if rates stay high, we will still get the yield.

As the yield curve chart shows, the big move in the last three months has been the rise in long-dated yields relative to short-dated, but the real story remains the much larger rise in yields overall since 2021.