The road to a bond bull market is paved, although challenges remain

Therefore, long-term rates might rise further as the following factors put upward pressure on yields:

• Central banks are sticking to their ’higher-for-longer‘ mantra. That means that while front-term rates remain anchored, the long part of the yield curve is free to rise.
• The Bank of Japan is looking to exit yield curve control. That means Japanese investors will gradually repatriate as domestic bond yields rise.
• Quantitative tightening (QT). All developed markets central banks are using policies to reduce their huge balance sheets by not reinvesting part of or all redemptions.
• Expectations of central banks to be done with the hiking rate cycle will motivate investors to engage in trades to benefit from the steepening of the yield curve. That means that investors will be looking to buy the front end of the yield curve and sell the long end, putting further pressure on long-term yields.

Hence, we might witness a last leg up in interest rates before they collapse as central banks get ready to cut interest rates. That's why we continue to favor short-term sovereigns, while we see scope to increase duration exposure towards the end of the year.

The moment to increase duration exposure is approaching

Inflation still poses a significant risk to bond investors. If it rebounds after central banks have reached their peak rates, it may mean more tightening is needed despite a profound recession. Although this decision will most impact the front part of the yield curve, it is important to note that long-term yields will soar too. That happened in the '70s: yields rose across maturities as stagflation aggravated. Yet, much smaller moves in long-term bond yields will produce more significant losses.

Two-year US Treasuries (US91282CHV63) now offer a yield of 5% and have a modified duration of 1.5%, meaning that if the yield suddenly rose by 100bps, an investor would lose only 1.5%. On the other hand, ten-year US Treasuries (US91282CHT18) have a modified duration of 8%.

Therefore, given that the inflation outlook is still uncertain, short-term bonds are ideal to park cash and wait for a better investment environment. At the same time, longer-term sovereigns become appealing once inflation has no chance to rebound.

As the recession deepens, inflation will become less of a concern. Better opportunities to add duration to one's portfolio will emerge towards the end of the year when central banks might be forced to ease the economy.

Stagflation creates the case for inflation-linked securities

Inflation linkers present a decade-long opportunity. Two-year US linkers (US912810FR42) are paying 3% in yield. Ten-year US inflation linkers (US91282CHP95) and 5-year US inflation linkers (US91282CGW55) pay slightly above 2%, offering the highest yield since 2008 and creating the tightest conditions since the global financial crisis.

The beauty of inflation-linked bonds is that they have dual exposure to inflation and rates. That means that if inflation rises, their notional and coupon will increase. However, if inflation reverts to its mean, linkers will gain from a drop in interest rates, despite paying smaller coupons and par at maturity.

Inflation is expected to remain elevated this year and the next despite the aggressive hiking cycle undertaken. We have, therefore, arrived at an inflection point where either rates are too high or projected inflation is priced too low in the market. In either case, inflation linkers offer an excellent risk-reward ratio under both scenarios in a well-diversified portfolio.

Junk bond spreads are poised to widen. Quality is king.

While real rates at 2% present an opportunity for savers, they threaten borrowers and growth. The only time real rates sustained above the 2% mark was between 2005 and 2007, preceding the global financial crisis. It would be naïve not to expect that real rates at historic high levels would not undermine risky assets today.

As stagflation deepens and central banks keep rates high, companies’ credit fundamentals will deteriorate. Businesses will face higher costs of funding, and the ability to adapt to a higher cost of debt will depend on a company's credit quality. 

Right now, the spread between junk and investment grade corporate is at the tight pre-COVID levels, with junk paying on average 270bps over investment grade bonds. Therefore, we expect decompression and the HY-IG spread to widen as defaults rise and interest coverage ratios come under greater pressure. 

We remain cautious and prefer quality over junk. Investment-grade corporate bonds are attractive, offering, on average, 5.1% in yield now, around the highest since 2008.