The increased likelihood that bond yields in the UK and US will stay higher for longer could make fixed income assets more attractive, according to industry commentators, despite money already flowing into the asset class in recent months.
According to the latest fund flow data from the Investment Association, published last week, the IA Corporate Bond sector saw the biggest sector inflows during the month of September at £904m ($1.91bn), far outpacing the second best-selling sector’s net retail sales of £244m.
This is no surprise given where interest rates stand relative to history, with developed market central banks now heading towards a rate-cutting trajectory. As such, however, there has been some concern over recent weeks that credit spreads are tight relative to history.
But could prospects for bonds have become even more appealing since?
While in the UK, the Bank of England’s Monetary Policy Committee voted 8-1 to cut interest rates by 25 basis points last week, it warned that policies implemented during last month’s Autumn Budget could increase inflation by up to 50 basis points at its peak. Figures from the Office for Budget Responsibility also confirmed the policies will increase inflation and impact the previous trajectory for interest rate cuts.
Meanwhile, in the US, the likelihood of inflationary policies from incoming president Donald Trump could also mean interest rates remain higher for longer. This is despite a rate cut from the US Federal Reserve last week.
Samer Hasn, senior market analyst at XS.com, said: “We are witnessing a gradual decline in the probability of the Fed cutting rates next January, reaching 20% today [13 November] after exceeding 60% a month ago. Also, if the Fed cut rates in January, the probability of further a cut in March is only 11%, after exceeding 60% a month ago, according to CME FedWatch Tool figures.
“The diminishing likelihood of a rate cut next year has driven yields on two-year treasuries—highly sensitive to shifts in short-term interest rates and expectations—up at a faster pace than 10-year treasuries. This surge has propelled two-year yields to their highest level since July, reaching 4.33% today.”
As a result, he said bond yields may “ultimately become more attractive” as investors capitalise on yields that could remain higher for longer than previously anticipated.
“Additionally, rising risk appetite in the markets, exemplified by record highs in stocks and cryptocurrencies… could lead Wall Street portfolios to shift toward a blend of high-upside stocks and high-yield bonds.”
That being said, a report from Bank of America Global research, published on the 11 November by credit strategists Ionnis Angelakis and Barnaby Martin, wanted that credit spreads have become “another leg tighter” since the US election result.
Despite this, they believe strong inflows into fixed income – namely credit – are likely to persist into 2025.
“The need for quality yield is here to stay. In a world of diminishing yields in “risk-free” proxies, like government debt and money-market funds, we think that credit will remain the asset in demand,” the wrote. “A growth shock could cause the inflow trend to wobble at times in 2025, but as long as the rates market doesn’t make a U-turn, we see strong inflows as a regular theme next year.”
Using rate volatility and the prevailing level of yields, the strategists predict that flows into investment-grade credit will be “strong” at between 5-7% of AUM in 2025, if yields continue to decline.
“We believe high yield will also benefit, but to a lesser extent, with flows of around 2.5-5% of AUM.
“Last but not least, there will be a clear decoupling between credit and government debt funds; the latter is likely to see more muted inflows of around 1.5-3.5% of AUM.”
Elsewhere, the research team at Square Mile said “cautious optimism” remains the dominant view among most fixed income managers that they speak with.
“In a climate of economic and political unpredictability, investors are increasingly turning to fixed-income funds as a strategic play for a more stable return profile,” the team said.
“The consensus at present is one of a “soft landing”, where growth slows without triggering a significant recession, although some managers commented that a “hard landing” remains within the realm of possibility. This creates both risks and opportunities for fixed-income assets.
“Trump’s victory may have profound implications for fiscal policy given his rhetoric around aggressive tariffs and immigration restrictions. Such policies may complicate the Fed’s ability to meet anticipated rate cuts, potentially leading to higher yields. Investors should consider that, while monetary policy is used to stimulate the economy, in developed markets the rate hikes resulted in relatively benign impacts as shown by the resilience in the US. This raises the question of whether the reaction to rate cuts may also be more muted than expected.”
From a duration perspective, the team said overweight positions in US and European interest rates look to be a popular strategy.
“Asset classes in favour are high yield, particularly in Europe due to cheaper valuations over the US, as well as emerging market debt and securitised assets. These asset classes are providing incremental and attractive levels of yield despite the tight credit spread environment.
“In the coming months, excess returns are more likely to come from carry rather than additional narrowing of credit spreads, i.e. capital appreciation. With spreads already compressed, focusing on yield seems to be the path most travelled in an attempt to offer a sustainable return profile.”
This article first appeared in our sister publication, Portfolio Adviser.
