2024: the return of the bond market

2024 looks set to offer investors a good entry point to the asset class.

Both 2022 and 2023 were dominated by high inflation and interest rate hikes, which led to a sharp repricing of more duration sensitive parts of the market – government bonds and investment grade corporates. While high yield corporate bond markets performed much better, we are now more cautious of the impact of elevated refinancing costs and a deteriorating economic backdrop on more highly leveraged corporate issuers.

At the same time, investors have once again been able to find attractive cash savings rates. Why do we believe bond markets, and in particular better quality corporate issuers offer an attractive opportunity? What is there to tempt investors out of cash?

The final months of 2023 saw a strong rally in the bond market off the back of rising optimism for swift and significant rate cuts. But 2024 started with central banks pushing back against market expectations. Markets have given back some of their gains. Yields for investment grade bond markets are attractive versus the levels we’ve seen for the past decade.

The new issue market has given us many opportunities across a range of different types of bonds. These include investment grade, corporate hybrids and subordinated financials. One area where we have been extremely selective is high yield.

Why we like investment grade

In investment grade, although credit spreads are tight, reflecting healthy fundamentals, attractive yields and relatively low net new issuance is already driving flows into the asset class. We’ve also seen a good amount of new issuance that we believe to be well priced, across the board.

Examples we’ve added to our more investment grade focused funds include:

• London Power Networks – issued a GBP 5.875% coupon, A- rated bond that matures in 2040
• Suez – EUR 4.5%, BBB rated, maturing 2033
• JP Morgan – EUR 4.457%, A rated, senior bond maturing in 2031

Some high yield caution

In high yield, there has been very limited new issuance over the past couple of years after corporates issued extensively in 2020 and 2021. As a result, the ‘maturity wall’ is getting ever closer and corporates will have to fund at much higher rates than they’ve previously been able to.

This, coupled with deteriorating economic data, including rising insolvencies and delinquencies, is making us more cautious on high yield.

In those funds with a bias towards higher yielding parts of the market we’ve been improving the overall credit quality. This reflects our view of the challenges that many high yield borrowers will face in an environment of higher borrowing costs, but also serves to protect against the risk of an economic slowdown.

Whilst it’s uncertain whether an economic slowdown will happen, we have far more certainty around the risks that higher borrowing costs pose to the high yield bond market. We’re very wary of those borrowers with higher leverage, whose balance sheets were put together in a very different borrowing environment. Even factoring in further declines in interest rates and yields, these companies may not be able to refinance at an affordable level.

It’s notable that there’s been a clear dispersion between the yield demanded for stronger and weaker credits. While the spread on European BB and B-rated bonds fell, those on bonds rated CCC and below rose substantially. 

This scenario, while challenging, should offer good alpha generating opportunities and will ultimately reward active portfolio management and a rigorous credit selection process. Although aggregate spread levels are not generous, we do still expect European high yield to deliver positive total returns in 2024 thanks to carry from the higher starting yield in the market.

Alternatives to high yield

While we’ve reduced exposure to high yield companies, we’ve been happy to take some more exposure to subordinated debt in stronger companies. We’ve increased investment in corporate hybrid bonds. These are junior bonds but the issuing companies are typically large, investment grade-rated names.

We’ve also added to subordinated financials, including AT1 bank debt. Following the sell-off last March, both banks and regulators have taken steps to ensure the continuing health of the AT1 market and it has performed well.

Example of recent issues include:

• Societe Generale – USD 10%, BB rated AT1, callable in 2028
• Barclays – USD 9.625%, BB rated AT1, callable 2029
• AXA – EUR 6.375%, BBB+ rated, callable 2033

In funds with a focus on delivering a high income, we can take a little more credit risk at the issuer level, and find examples such as:

• Co-Operative Bank – GBP 11.75%, BB rated. Subordinated bond maturing 2034
• Virgin Money – GBP 11%, BB rated AT1 callable 2029

To answer our earlier question, of what’s out there to tempt investors out of cash - interest rate cuts are expected from the US Federal Reserve, European Central Bank and Bank of England in the first half of this year. Falling interest rates will feed through quickly to the rates achievable on savings accounts.

In bond markets though, we continue to have the opportunity to ‘lock in’ attractive income streams that can benefit the funds for many years, without taking on too much in the way of credit risk. We have already started to see early signs that investors are reallocating from cash to bond markets, especially investment grade.