Monthly fixed income update

Asset Class Returns

Bond markets continued to rally in December, once again providing positive returns across the fixed income spectrum. In fact, the 5.0% return in November followed by a further 4.2% gain in December makes it the strongest two-month return for the Bloomberg Global Aggregate Index in the last 30 years.

The ongoing trend of weaker data combined with a more dovish outlook from the Federal Reserve provided the backdrop that was needed to further boost returns on equities and bonds. Indeed, the Fed’s updated summary of economic projections showed inflation, and specifically their favoured core PCE measure falling more quickly than they had anticipated in September; while the “dot plot” of rate expectations also indicated a faster pace of rate cuts next year. With the Fed now anticipating rates to be 50bp lower at the end of 2024 than they had forecast in September, due to no further rate hikes and an additional cut, it gave the market the green light to drive rate expectations lower, which in turn caused a strong rally in bond yields and credit spreads. 

This turnaround in bond market fortunes in the last two months has also led to positive returns across fixed income for the 2023 calendar year. Considering US Treasuries and USD-denominated investment grade credit returns were negative for the year as recently as early November, ending the year up 4.1% and 8.5% respectively shows just how strong the recent rally has been. Additionally, it’s worth mentioning the incredible recovery in the AT1 market which was down by almost 17% at the lows post the Credit Suisse write down in March but ended the year up 2.6%.

Government and Inflation-Linked Bonds

Following their strong performance in November, government bonds continued to firm early in the month driven by data indicating signs of weakness in the US economy. But it was the statement and updated summary of economic projections that accompanied the Fed’s decision to keep rates on hold for the third consecutive meeting, in the middle of the month, that was the main catalyst for bond markets to rally further.

US Rates

Earlier in the month, survey data along with durable goods orders provided ongoing signs that the US economy was slowing which continued to support the US bond market. But it was the Fed’s pivot to a more dovish outlook in the middle of the month that caused a stronger market rally. Having held rates in their December meeting, the accompanying statement acknowledged that “recent indicators suggest that growth of economic activity has slowed from its strong pace in the third quarter” as well as stating that “inflation has eased over the past year” although they did also say that it remained high. But the summary of economic projections confirmed the more dovish tone, showing they anticipated inflation to fall more rapidly than in September and now expect rates to end 2024 at 4.6%, 50bp lower than they had forecast three months ago. 

Eurozone Rates

European government bond markets once again took their lead from US Treasuries. However, performance also benefited from the generally positive attitude to risk seen in markets, with peripheral government bonds rallying more than core markets until Christmas, before giving back some of the gains into month end, as spreads versus Bunds approached the tightest levels of the year. The ECB held rates for the second meeting in a row but did not pivot to a more dovish outlook with comments broadly indicating that it was too early to consider easing rates.

UK Rates

The gilt market also rallied in December, driven by a combination of the global backdrop, weaker domestic data and by UK inflation data falling more quickly than had been anticipated. The Bank of England held rates for the third consecutive meeting while, at 3.9%, CPI is now at the lowest levels for over two years which should continue to provide a supportive environment for UK bond markets. Nevertheless, it did mean while they had an incredibly strong month, real yields on index-linked gilts rallied by less that yields on the nominal counterparts as breakeven inflation rates narrowed over the month.

Investment Grade Credit

While the dovish rate outlook provided the positive environment for investment grade credit, the rally in spreads was slightly subdued following the aggressive tightening seen in November. However, USD spreads tightened by 5bp while EUR and GBP spreads both tightened by 9bp meaning spreads in all three currencies are at the tightest levels of the year.

High Yield and Subordinated Credit

Lower rated credit continued to perform well with the Fed’s dovish tone mid-month accelerating spread tightening. High yield spreads in USD and EUR rallied by 47bp and 44bp respectively while spreads on subordinated debt rallied by 37bp for AT1s and by 21bp for EUR Corporate Hybrids. While AT1 spreads have been unable to rally back to the tightest levels of the year seen in February they have recovered to end the year tighter than they started which is a stunning turnaround considering the impact the Credit Suisse write down had on spreads and confidence in the AT1 market in March. However, the ongoing credit rally has left USD and EUR High Yield and EUR Corporate Hybrid spreads at the tightest levels of the year.

Fixed Income ETF Flows

Although net inflows slowed into year-end, fixed income ETFs still recorded $5.1bn NNA in December. That takes net inflows for the year to $68.2bn, the strongest calendar year for fixed income ETF inflows. But, now that it appears that rates have peaked in most developed markets and are likely to be cut in the coming 12 months, and with record levels of cash waiting to be put to work, 2024 is likely to continue to see strong inflows into fixed income ETFs.

For December, EUR government bonds ($1.5bn) was the leading category for inflows, closely followed by EUR ($1.5bn) and USD ($1.4bn) investment grade credit. The relatively new category of fixed maturity bonds ($0.6bn) also continued to see strong demand. US Treasuries (-$1.21bn) led the outflows followed by inflation (-$0.6bn) and China bond (-$0.3bn)

Fixed income markets have rallied strongly over the last two months, driven by weaker economic data, the end of the hiking cycle and has been spurred on by the Fed pivoting to a more dovish outlook for rates. While this backdrop is likely to provide support for fixed income in the coming year, markets may need to pause given the strength of the rally into year-end. Nevertheless, with rates likely to come down during the year ahead, fixed income is likely to remain in demand as investors put cash to work and lock in longer term yields before interest rates are cut.

With net inflows of $68.2bn, 2023 was the strongest year on record for fixed income ETF NNA. The broad theme for the year was that demand was focused on higher quality fixed income as the yield available meant there was less need to take on additional credit risk, with developed market government and investment grade credit accounting for 80% of net inflows during the year. US Treasuries ($15.2bn) were the leading category followed by EUR-denominated investment grade credit ($13.2bn) and EUR government bonds ($13.2bn). Aggregate ($6.1bn), Cash Management ($5.1bn), and UK Gilts ($4.3bn) also saw strong demand. Outflows were limited with only Inflation (-$2.5bn), Floating Rate (-$1.3bn) and China Bond (-$1.3bn) the only categories that saw outflows over $1bn.