As we approach the mid-point of another volatile year in markets, we sat down with Mike Matthews, Co-Head of Invesco’s fixed income team in Europe. He shared his thoughts on bond market performance so far in 2024, delving into some of the key headwinds that investors have had to navigate.
Mike believes that increasing duration and reducing credit risk is the order of the day. Read on for further details, and to discover how this is influencing his management of the Invesco Corporate Bond Fund (UK) and the Invesco Sterling Bond Fund
Yes, we’ve spent a lot of time thinking about monetary policy and our duration positioning. Investors started the year expecting several cuts from the Fed and the European central banks. Market pricing was for six cuts (from 5.5% to 4%) in the US and about the same number in Europe. Now, pricing suggests something around 50bps for the ECB and the Bank of England (BoE) and maybe not even 25bps from the Fed.
Growth data has been better and monetary policymakers have talked up rates, so that’s been a headwind for government bonds. Despite quite high starting yields, total returns on Treasuries, Bunds and Gilts have been negative. The Gilt index was -5% for the year to the end of April (it’s come back a bit since).
Government bonds were strong in the last months of 2023, so the market was probably due a breather, but there’s no doubt that duration has dragged on returns.
We held a lot of duration at times in 2023 but I reduced it in Invesco Corporate Bond Fund (UK) and Invesco Sterling Bond Fund at the end of the year, into the big rally. I’ve increased it again as yields have risen this year. So far, that hasn’t worked. It feels a bit like last year. We built duration when yields were high but we didn’t gain from it until the market finally turned in Q4.
We’re positive. Duration has been a drag on returns year-to-date, but I’ve felt comfortable adding at these yields. If rates stay where they are, that’s okay. If expectations for cuts increase, we should do well.
Yes, in my view they probably will. The macro background makes it easier for them. Growth is slower, so they have more justification for cutting, and lower forecast inflation gives them room. In the most recent meetings, both the ECB and the BoE have moved towards a cutting stance.
It’s unusual. The Fed has normally been the first to move and the central banks don’t seem to like getting much out of step with each other, but I think the market is right to price in some cuts from both the ECB and the BoE in the next few months.
I’m holding virtually zero USD duration. When we’ve added, there has been better value in gilts and I’ve been comfortable with that. But one thing to remember is 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 and Gilts will move too.
We’ve added some linkers this year. With all the focus on how sticky inflation might prove to be, there’s a natural interest in the hedge they offer. I think valuations have improved. Linkers have underperformed conventionals for the last few quarters as inflation has moderated. The breakeven rate (the expected rate of inflation implied by the pricing of index-linked bonds) is looking more attractive. There are also technical factors that I think are supportive. A lot of conventionals are going to be issued but supply of linkers looks more constrained. There must also be pension funds thinking about locking in to index-linked yields.
It’s certainly an easy argument to make. GBP 3mth is over 5% and there’s no rate risk. But our reasoning for being further out the curve, despite the lower yields, is the same as it was a year ago. First, the short-end yield is high now but how long can you lock it in for? What rate will you get when you need to re-invest? And second, by holding duration we get more than just the yield – we get sensitivity to change in rate expectations. That’s what duration is. If expectations fall, our funds, with a duration of 6 or 7, will get a lot more capital return than short-dated investments.
That’s not to say that we are making no use of the short rates that are available. I have a few percent of my portfolios invested in short-dated corporates. It’s not the same as cash, but I see it as a source of liquidity if I need it. With a bit of spread on top of the gilt curve, my all-in yield is 5.5% on a group of high-quality corporate bonds that will roll off over the next year.
I feel like there’s not much to talk about in the credit markets, from a top-down view. Spreads are a lot tighter than a year ago, but they are also quite stable. There’s been lots of investment grade issuance but it’s been well received by investors.
I think that there’s limited value and prefer the ‘reward to risk’ ratio in higher quality credits. I’m more comfortable with the yield (and the potential upside) I’m getting from rate risk than from credit.
Over the last few months, the theme in my portfolios has been de-risking on credit. Adding those short-dated securities is an easy call. We’ve also been reducing subordinated insurance (RT1), selling and also not replacing when bonds have been called.
We’ve been rotating out of high quality names where the spreads have tightened. In weak periods over the last couple of years I’ve used bonds like Shell 1.75% 2052, University of Oxford 2.544% 2117 and Wellcome Trust 2.517% 2118 to add duration and some high quality spread at good prices. But now I don’t see much upside on their spreads and so I’ve been selling and buying gilts instead (to maintain duration). This is not really about any credit worries, just a valuation call.
I think banks still look reasonably cheap. We’re holding more in that sector. We’ve often been enthusiastic about subordinated banks debt but now I’m more focused on the seniors. I’d say we’ve rarely had as much sterling senior bank paper in Corporate Bond and Sterling Bond. You get a little less yield but the risk mitigation 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.
Overall, the market is feeling tight and I’m trying to be disciplined on what I buy. There have been some interesting stories at the issuer level, which we’ve been following closely.
We’ve been early on de-risking on the credit side. Credit spreads have remained quite tight but I think there will be an opportunity to add credit at weaker levels and I’m happy with the portfolios I have.
A stable market is fine for us. We’ve moved to having a bit more rate risk and bit less credit risk, but the all-in yield is good, just a bit under 5.5% on a gross basis. If things stay as they are, that’s okay.
With our positioning, we’ll probably underperform if spreads tighten more. We’re also more likely to outperform if more rate cuts get priced in and we get capital return from our duration.
Mike Matthews, who shared his insights with you today, is Co-Head of Invesco’s fixed income team in Europe. He has been managing sterling corporate bond portfolios since 2006.
Mike’s portfolios follow a time-tested approach based on fundamental analysis, with a strong emphasis on valuation. Click below to learn more.
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Invesco Corporate Bond Fund (UK): The Fund is theme-based or invests in a specific sector or a small number of sectors and/or industries. Investors should be prepared to accept a higher degree of risk than for a Fund that is more widely diversified across different sectors/industries. The debt securities that the Fund invests in may not always make interest and other payments and nor is the solvency of the issuers guaranteed. Market conditions, such as a decrease in market liquidity, may mean that the Fund may not be able to buy or sell debt securities at their true value. The Fund has the ability to make use of financial derivatives (complex instruments) which may result in the Fund being leveraged and can result in large fluctuations in the value of the Fund. Leverage on certain types of transactions including derivatives may impair the Fund’s liquidity, cause it to liquidate positions at unfavourable times or otherwise cause the Fund not to achieve its intended objective. Leverage occurs when the economic exposure created by the use of derivatives is greater than the amount invested resulting in the Fund being exposed to a greater loss than the initial investment. The Fund may invest in contingent convertible bonds which may result in significant risk of capital loss based on certain trigger events. The Fund’s performance may be adversely affected by variations in interest rates.
Invesco Sterling 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. Investments in debt instruments which are of lower credit quality 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 extensively in contingent convertible bonds which may result in significant risk of capital loss based on certain trigger events.
Data as at 23/05/2024 unless stated otherwise. Views and opinions are based on current market conditions and are subject to change.
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