Bonds: Rate Risks Coming Into Balance
June 2024
While interest rate volatility is likely to persist as market participants overreact to incoming economic data, upside and downside risks for yields could move more into balance in the coming months, leading to some relative stability in the bond market. Inflation remains sticky and progress on bringing inflation down to the FOMC's two percent target is likely to remain painfully slow, but we continue to expect price pressures to ease over the balance of 2024 and 2025, putting modest downward pressure on long-term Treasury yields in the process. The size of upcoming Treasury auctions amidst a buyer's strike from abroad (China, Japan) has created angst on the part of investors and has played a role in driving investors into shorter duration bonds. Treasury secretary Janet Yellen has taken notice of this preference for short-term paper and has responded by issuing larger amounts of bills and notes as opposed to longer dated bonds, which has helped keep a lid on yields farther out on the Treasury curve. The U.S. Treasury shifting issuance to the short end of the curve, along with the FOMC allowing $25B per month of Treasuries to run off its balance sheet starting in July, well below the current $60B per month, should prevent yields from running away to the upside, in our view.
Conversely, we see few reasons for Treasury yields to fall materially over the near-term. The U.S. economy is still on a path to approximately 2% growth this year and inflationary pressures will likely ease only gradually over the coming quarters. The labor market remains strong and average hourly earnings have risen 3.9% or more year over year in every month this year. A resilient U.S. economy and labor market strength, combined with political risk in the euro area keeping upward pressure on sovereign yields abroad should put a floor under U.S. Treasury yields not too far from current levels as investors will want to be appropriately compensated for taking on the risk that inflation and/or economic growth reaccelerates in the coming months. We see Treasuries as fairly valued at present, with long-term bonds tilting more toward 'rich' than 'cheap' after the drop in yields at the start of June. As a result of this view, we maintain a duration profile in-line with that of the Bloomberg Aggregate Bond index as a 'coupon clipping' backdrop remains in place.
Few Signs Of Stress In High Yield, But Credit Spreads Unlikely To Tighten Much From Here. Riskier corporate bonds have had a relatively strong start to the year, with the Bloomberg U.S. Corporate High Yield index turning out a respectable 1.6% gain through May, outpacing the Bloomberg Aggregate (Agg) Bond index's 1.6% decline and the Bloomberg Corporate Bond index's 1.1% drop. The Corporate High Yield index's strong relative performance has been due to the shorter duration profile of the index which makes it less sensitive to rising interest rate than are the Treasury-heavy Agg and the investment-grade only Bloomberg Corporate index. Higher yielding corporate bonds have been boosted by strong investor risk appetite and by expectations that the U.S. economy will remain resilient, a combination serving to modestly tighten credit spreads throughout the first five months of this year. Yields on riskier corporate bonds did move higher in early June as fears of a U.S. economic slowdown forced Treasury yields lower and investors required greater compensation for taking credit risk, but credit spreads remain tight by historical standards and are far from levels that might indicate stress or fear on the part of investors. We maintain a neutral allocation to high yield corporate bonds, but investors should temper expectations as credit spreads are unlikely to tighten in much from here, setting up a scenario in which holders receive their coupon but little else from exposure to the asset class.
Emerging Market Debt Still A Strong Contender For Capital. Debt issued by emerging economies was among the top performing fixed income asset classes in May as the J.P. Morgan Emerging Market Bond index (EMB) generated a 2.6% total return as a higher yield and longer duration profile were rewarded. May's rally took the trailing 12-month total return on the EMBI to a more than respectable 10.4%. Such a strong advance during a period in which the Bloomberg Aggregate Bond index generated just a 1.3% total return, has prompted valuation concerns. When viewed through the lens of option-adjusted spreads (OAS) relative to U.S. Treasuries, upside in emerging debt appears limited with a current yield just 253-basis points above the yield on U.S. government securities with a similar duration, which is below the 20-year average of 329-basis points. Historically, a tight spread such as this has often signaled that yields on emerging market debt are no longer high enough to compensate investors for credit, interest rate, and political risk, among others, but that isn't necessarily the case this time around.
Yields on emerging market debt are still over 7%, or 100-basis points above the 20-year average, so the reason the OAS has narrowed is that Treasury yields have risen, not because yields on EM debt is well below historical levels. Put simply, higher treasury yields due to sticky and elevated U.S. inflation may mean EM debt is cheaper than it appears. One way to gauge this is by comparing the historical excess yield between the broader developed sovereign debt market relative to emerging debt yields. As of the end of May, EM debt held a 4.2% yield advantage relative to the developed sovereign benchmark, right in line with its 10-year average.
That's far from extreme overvaluation when one considers the stronger fiscal discipline required on the part of emerging countries to float debt and fundamental improvements sweeping across the emerging markets landscape which leave current yields within an acceptable range, in our view. One potential concern stemming from this assessment is that tight spreads in risk assets can lead to price declines as investors demand more yield, but spreads can also widen if Treasury yields decline and emerging market yields mark time and move sideways. Alongside potential upside catalysts including a stronger U.S. dollar and lower U.S. rates, lead us to maintain a constructive stance on EM debt, even if we aren't looking to increase exposure at current yields/spreads.
As of June 13, 2024
