January’s optimism about the bond market seems like a long time ago.
The best corporate bonds have erased almost all of their early-year gains as stubborn inflation data lead traders to reverse course on the timing of rate cuts by central banks. Total return from that debt is now just 0.67% since the start of 2023 following the worst February on record, according to Bloomberg indexes.
It’s a remarkable turnaround for high-grade bonds, after a record jump in January in the same metric. Lingering inflation and the fading likelihood of a Federal Reserve rate cut this year risk flipping the “year of the bond” narrative that suggested buyers of the safest credit couldn’t go wrong thanks to the highest yields in about a decade.
“The risks are skewed to the downside: spreads should go wider,” said Viktor Hjort, global head of credit strategy and desk analysts at BNP Paribas SA. “There’s been a nice growth narrative of late but I’m concerned that the market underestimates the fact that most policy tightening in the US and Europe has yet to hit the economy and corporate fundamentals.”
Four weeks since the market’s peak on Feb. 2, the global high-grade bond market has lost almost $327 billion in value, more than the gross domestic product of Chile. The market took another leg down on Tuesday, with data showing everything credit bulls hoped to avoid.
First, higher-than-expected inflation figures in France and Spain fanned fears of a strong response by the European Central Bank. Later in the day, bond traders downgraded their projections of a rate cut by the US central bank this year to a coin toss.
‘Bumpy Ride’
Money markets are now placing even odds that the Fed Funds range will peak at between 5.50% and 5.75% by July, meaning credit markets are in for a “bumpy ride,” Kathy Jones, chief fixed income strategist at Charles Schwab & Co., said in an interview. Until there’s a “clearer picture” of what the central bank’s expectations are, volatility will continue to impact the market.
| The year of the bond begins to fizzle |
- Total return in the €2.4-trillion euro-denominated high-grade market dropped from 3.7% in early February to just 0.75%
- Investment-grade dollar bonds from emerging-market Asian issuers lost 1.6% last month, the second-worst February on record for the notes, according to data compiled by Bloomberg that goes back to 2009
- 377 of 429 all-new investment grade issues sold during the first two months of the year in Europe are trading below their issue prices, data show
- A Bloomberg gauge of global government bond returns is down so far in 2023, even after its worst calendar year on record.
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That’s not deterring asset owners for now as they continue to pile into fixed-income products, drawn by yields that are almost double the past 10 years’ average.
European funds investing in high-grade bonds have drawn investor cash for 18 consecutive weeks, based on EPFR Global data compiled by Bank of America. Inflows this year alone amount to almost $27 billion. US-domiciled investment-grade funds have added almost $41 billion this year.
“Higher yields are supportive of ongoing inflows” into the asset class, said Mark Benstead, head of pan-European credit at Legal & General.
The froth of money in January in particular saw borrowers rush to the market to take advantage of the inflows. In the US, for example, more than $300 billion of investment-grade bonds have been issued since the start of the year, according to data compiled by Bloomberg.
Rush to Market
Many of the deals were sold earlier than scheduled, Dave Del Vecchio, co-head of US investment grade corporate bonds at PGIM Fixed Income, said in an interview. March could provide better technicals because of lower issuance and a low number of acquisition debt financings, he added.
“While investors are happy to earn a higher degree of income within markets they are also scarred from the price action of 2022,” James Dichiaro, senior portfolio manager at Insight Investment, said in a message. “The specter of yet higher rates from here is enough to cause investors to pull back, reassess, and await a better entry point, which we have witnessed in February.”
Money managers have become progressively more conservative after blue chip corporate debt had the worst year on record last year, focusing on high-quality borrowers or passing on new issues that offer little in terms of price sweeteners.
More recently, investors have been voicing their preference for short-dated debt, which pays as much — if not more — than longer notes but with little risk of price plunges as yields keep going higher.
“Investors need to have a longer-term horizon,” said Al Cattermole, a portfolio manager at Mirabaud Asset Management. “If you don’t need the money in six weeks, this is a very attractive asset class.”
To be sure, this time around the setback has mostly affected the more rate-sensitive parts of the credit market. Junk-rated bonds, which are generally shorter duration than investment-grade debt, remain up 2.4% up for the year because their yield is less sensitive to government bond gyrations. However, even they have shed the majority of their year-to-date gains.
Still, a prolonged effort to tame rising consumer prices could end up hitting the economy and earnings, adding to credit investors’ headaches.
“The strength of the rally in the first six weeks or so of the year surprised us a bit as our base case scenario for 2023 was higher rates eventually leading to a slowing economy, lower earnings and higher cost of funding,” said Pauline Chrystal, a portfolio manager at Kapstream Capital in Sydney. “We have seen a bit of a rerun of 2022 - rates sell off and credit sells off.”
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