Peak, plateau or progression: why now is a pivotal moment for corporate bond investors

The annual Economic Policy Symposium at Jackson Hole in Wyoming is always closely scrutinised, but perhaps more so this year as bond markets contemplate whether we are at a peak, plateau or progression in interest rates. Despite the old adage that they do not ring a bell at the top (or bottom) of the market, ears were nonetheless straining to hear one.

For the US, Federal Reserve (Fed) Chairman Jay Powell came out a touch more cautious than had been expected. While headline inflation has been coming down steadily in recent months, his speech focused more on the stickiness in the core Personal Consumption Expenditures Price Index (PCE), which remains at over 4%.      

“Although inflation has moved down from its peak – a welcome development – it remains too high. We are prepared to raise rates further if appropriate, and intend to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective.”

Meanwhile, European Central Bank (ECB) President Lagarde struck a robust tone. This was perhaps to be expected given the single mandate for price stability, and was borne out the higher-than-expected inflation numbers released on 31 August:

“In the current environment, this means – for the ECB – setting interest rates at sufficiently restrictive levels for as long as necessary to achieve a timely return of inflation to our 2% medium-term target.”

Bank of England Deputy Governor Ben Broadbent concurred with his counterparts, saying “it is likely that monetary policy will have to remain in restrictive territory for some time.”

While all three left enough ambiguity not to commit to any interest rate rises at the forthcoming meetings (the ECB did hike on 14 September, while the Fed and BoE held on the 20th and 21st respectively), the reasonable inference is that rate cuts are not on the horizon unless and until inflation data reach the 2% threshold and settle there.

This stands against market pricing, which is currently indicating that cuts could begin as soon as May in the US and April in the Eurozone.

What does this mean for corporate bonds?

Corporate bond spreads – the additional interest rate premium companies have to pay over government bonds - have narrowed over the last year as several market concerns have been allayed. First, the world economy proved able to withstand an energy shock and sharp interest rate hikes. Then, the collapse of US regional banks and Credit Suisse turned out to be idiosyncratic rather than systemic.

On spreads alone, valuations are not as compelling as six or twelve months ago (Figure 3). Rather we are slightly inside the long-term median (i.e. mid-point) for US corporate bonds and somewhat outside for Europe. But this is reflective of a diminished risk environment and reasonable corporate fundamentals. Furthermore, from an aggregate perspective, the picture looks more attractive (Figure 4). 

As you can see from Figure 4, nominal yields for both US and European investment grade bonds are at levels not seen for more than ten years. More importantly, they are both offering real rates of return after expected inflation – again at levels not seen since the Global Financial and Euro Crises.

They are also comfortably ahead of equity dividend yields – so our analysis from last year¹ remains valid. In other words, bonds are once again a viable option for investors as they look to meet their return goals. 

Reflecting on what this environment means for pension schemes specifically, Ashar Muhammad drew attention to some changes in asset allocation trends. Ashar is a member of Invesco’s UK Pensions and Consultant Relations team. He commented:

“The LDI crisis last year was a difficult time for most UK DB schemes, but they have generally come out of it with improved funding levels. As investment strategy reviews are underway, there are some broad asset allocation trends that we are already observing – a greater focus on liquidity, portfolio de-risking, and a better appreciation of the desired endgame. Going forward, we expect an increased allocation to fixed income, especially buy and maintain credit, which is ideally placed to meet the emerging needs of UK DB schemes”.  

We expect yields to peak as monetary policy bites

Could yields continue higher? Of course, but probably only as the result of a deterioration in the corporate outlook, higher inflation, or a more aggressive central bank policy stance.

Our team’s base case, however, is inclined towards a topping out due to slowing inflation and growth as restrictive monetary policy bites. Softening forward-looking indicators such as the Purchasing Managers’ Index (which tracks economic trends from private sector manufacturing and service companies) seem to support this thesis.

We are overweight duration² in our benchmark-aware accounts, particularly in the UK and front-end US.³ We also think that buy and maintain investors have a potential opportunity to take advantage of these positive real returns for the longer term.