This year has been a roller-coaster for the bond market as alternating waves of pessimism and optimism mirrored the wide swings in economic data. However, higher-yielding sectors, such as high-yield corporates and hard currency emerging markets debt, continued to post positive returns, albeit slower than in 2023.
An environment of high and stable long-term rates supports the fixed-income bull case. This will be a disappointing market for those seeking a quick drop in yields. Even with the likelihood of rate cuts, long-term yields should remain centred around current levels as a fair amount of rate cuts are already priced in and loose fiscal policy — and its resulting heavy government bond issuance — may impede any substantial, sustained decline in long rates.
This will likely result in a slow normalisation of the yield curve with little change in the range for long rates despite any drop in short rates.
The appeal of bonds is in strategic value
A range-bound rate backdrop may seem like an uninteresting opening volley for a “bullish thesis for bonds”. But this stability provides context to a few strategic points as events unfold in the second half of the year and beyond.
First, from an asset allocation perspective, the value of bonds is not to be underestimated, given the shifts in valuations and the current point in the economic cycle. If history is any guide, the shift in relative value over the last few years — particularly the cheapening of bonds versus stocks—has typically positioned bonds for competitive risk-adjusted returns.
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Second, the defensive characteristics of bonds at this point in the cycle are striking. If stocks experience a sharp correction while the Fed is on hold or cutting rates, bonds historically perform as solid shock absorbers in investors’ portfolios.
Lastly, the long-term outlook for positive excess returns from credit — albeit at a less fevered pitch given the level of spreads — remains favourable thanks to positive fundamentals, issuer restraint, and a benign technical backdrop as investors move into fixed income to lock in higher returns at the peak of the interest-rate cycle.
Short-term volatility still expected
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Nevertheless, short-term volatility is a much tougher call. Although we expect relatively stable rates over the long term, the summer is notorious for lower liquidity and outsized reactions to shocks, of which any number are possible: Eurozone or US debt concerns or rising geopolitical risks in the Mideast, South China Sea, or even in the Western hemisphere as Russia increases its military presence.
When looking through q-o-q fluctuations, the strategic case for bonds remains strong. In our base case, the stealth bull market continues — one not generated by a drop in rates but simply by the accumulation of yield itself.
Meanwhile, we continue to see opportunities to add value in a volatile market. From an asset allocation perspective, the case for bonds is solid, given their current relative valuations and their potential to act as shock absorbers at this point in the market cycle.
In the longer term, the outlook for fixed income as an asset class looks strong on an absolute and relative basis, with ample opportunities to add value through sector rotation and issue selection in volatile markets.
Impact of loose fiscal policy and rising government indebtedness
Periodically, but with increasing frequency, the attention of investors turns to loose fiscal policy and rising levels of indebtedness. When investors are optimistic about disinflation and rate cuts, they do not seem to worry about debt burdens, deficits, and government bond issuance. But the fact is that debt burdens for countries like the US and France are adding up as bouts of stimulus for crises, such as the global financial crisis and Covid, get piled on top of what are already perennially high deficits.
In other words, the 90%+ highly indebted zone has gone from a rarity among DM (developing market) countries to more of a norm. The impact of these higher debt burdens is twofold. Firstly, it leaves markets vulnerable to bouts of volatility. Secondly, higher debt burdens lead to a chronic increase in the average, long-term cost of a government’s debt service.
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The long-term increase in debt-service costs resulting from heavy issuance can be seen in the progression of higher government yields relative to supply-neutral benchmarks, such as swap rates — the swap spread. Over the last few decades, US Treasury yields have risen relative to swaps along with the increase in the government’s level of indebtedness. As the government swung from a situation of surplus and paying down the debt to one of yawning deficits and a strikingly high debt-to-GDP ratio, the Treasury’s cost of issuance has risen by roughly 2% relative to a supply-neutral benchmark.
Government indebtedness can cut both ways in the Eurozone. For example, thanks to Germany’s relatively low debt levels, the country’s bunds trade at lower yields than swaps. Meanwhile, heavily indebted credits, such as France and Italy — analogous to the US — have to pay yields above swap rates due to their higher levels of indebtedness.
Our takeaway is that government indebtedness is increasingly becoming a market driver in the post-Covid-19 environment. Government yields versus swaps will continue to be profoundly impacted by debt trajectories, creating risks and opportunities for credit investors.
Robert Tipp is chief investment strategist and head of global bonds at PGIM Fixed Income.
