Bonds: What to do until inflation stabilises

Strong demand to underpin corporate bonds as yields remain attractive

Despite a continuous deterioration in corporate bonds, investment-grade corporate bonds are likely to remain well bid as direction on inflation remains uncertain, and primary markets enter hibernation. As the Fed slows down QT and the ECB begins to cut rates, a further tightening of credit spreads is likely.

Similarly, high-yield corporate bonds are expected to remain underpinned throughout the third quarter. While spreads in the junk bond market are tight compared to historic averages, high-yield bonds have proven to be a crucial hedge against inflation over the past two years. With ongoing uncertainty about central banks' success in combating inflation, high-yield corporate bonds are anticipated to remain supported despite weakening fundamentals. In this environment, cherry-picking and bottom-up analysis become critical.

Investment implications

Performance in rate markets remains closely tied to the path of inflation. As the divergence between the US and Europe continues, it is important to maintain a cautious stance and limit duration exposure. Therefore, we remain positive on quality and maturities up to five years, while remaining cautious on credit risk and longer durations.

Developed markets' front-term rates have peaked in 2023, offering a win-win scenario for bond holders. For example, assuming a one-year holding period, the 2-year US Treasury yield would need to rise above 10.6% to result in a negative return, while the 2-year German Schatz yield would need to rise above 6% to provide a negative return over the same period.

Long-term rates remain vulnerable to the pace of inflation returning to 2% and a possible rebound in the term premium, especially as concerns over the sustainability of deficits grow. If US economic exceptionalism continues, ten-year US Treasury yields might rise to test 5% once again, dragging European sovereign yields higher, too.