Bonds on everybody’s lips

With central banks likely cutting rates slowly, the lagged transmission of aggressive monetary policies from 2023 will continue to tighten financial conditions in the new year. This would favor extending duration and quality in the medium term.

There are three possible scenarios for developed market sovereign bonds in 2024:

1. Soft landing scenario: the battle against inflation is over, and a deep recession is avoided, causing central banks to cut rates slightly, but not aggressively. Yield curves would bull steepen, with 10-year yields adjusting moderately lower from where they are today.
2. Hard landing scenario: a deep recession forces central banks to cut rates aggressively, provoking a deep bull steepening of yield curves. Rates would fall considerably across tenors.
3. The 70s scenario: inflation reignites, forcing central banks to hike again. This would see yield curves bear flattening, with front-term yields offering a considerable pickup over long-term yields.

Quality is king

Deteriorating economic activity and high rates do not bode well for risky assets, which could lead to higher corporate bond spreads amid slowing revenues and compressed margins.

While yields on corporate bonds in the US and Europe have risen together with sovereign yields, the pickup that investment-grade corporate bonds offer over their benchmarks is well below the 2010-2020 average. 

When looking at junk, the picture is even more depressing. USD high yield bonds pay 260 basis points over comparable investment grade bonds, a level in line with pre-Covid valuations when the Fed was stimulating the economy through quantitative easing and interest rates were less than half what they are today. In Europe, junk pays 310 basis points over high-grade peers, reflecting a more challenging macroeconomic backdrop.

Therefore, we see better value in developed market sovereigns, although a selective approach for corporate bonds remains compelling.