Fixed income: Keep calm, seize the moment

The Fed and ECB are likely to begin cutting rates around summer. Yet, policymakers will reinforce the message that they remain data driven and will proceed slowly as inflation remains above the 2% target.

If rate cuts do not materialise, a hard landing becomes more probable, particularly in the Euro area, where the economy has been stagnant since December 2022.

Investment-grade corporate bonds

Credit deterioration will accelerate as the economy slows, resulting in rating downgrades. Excluding pandemic highs/lows, investment-grade corporate bonds currently have the highest leverage on record, and the lowest investment coverage since the global financial crisis, making bottom-up analysis and cherry picking crucial.

High-yield corporate bonds

The high-yield corporate space is facing a double hurdle: deteriorating fundamentals, and increasing refinancing risk, as they approach a wall of maturities in 2025. Yet, as central banks prepare to ease financing conditions, junk bonds are likely to remain underpinned.

Investment implications

As the Federal Reserve and the ECB prepare to cut rates, there is scope to extend a portfolio’s duration up to 10 years.

Developed markets front-term rates have peaked in 2023 and offer a win-win scenario for medium-term and long-term holders. As an example, assuming a 6-month holding period, 2-year US Treasury yields need to rise above 6.1% to provide a negative return.

US long-term rates remain vulnerable to the pace of inflation returning to 2%, and a possible rebound in term premium. In case of a slower than expected disinflation trend, yields of US Treasuries with maturity more than 10 years might rise further despite the Fed beginning to cut rates. In Europe, long-term rates are fair, but we remain cautious on ultra-long maturities.

Investment-grade corporate bonds

Despite credit fundamentals deteriorating, investment-grade credit spreads will remain range bound as investors rotate from risk to quality.

High-yield corporate bonds

High-yield spreads are likely to widen gradually amid a slowing economy. Yet, demand is likely to remain robust as, on average, junk bonds on both sides of the Atlantic pay a yield above the past 14 years’ average.