What potential rate cuts could mean for bonds

The start of 2024 promised a bright future for corporate bonds. Interest rates looked set to fall, which would have pushed yields lower and raised bond prices. Default rates had ticked higher, but not enough to frighten investors, while yields of 5% or higher meant investors had a good layer of protection.

It has not worked out quite as well as hoped. Inflation has been more persistent than bond markets had expected, and interest rate cuts have been pushed out. While high income levels have cushioned the blow, investors have received little or no capital growth from corporate bonds year-to-date.

The performance of corporate bonds has two main influences: the government bond yield and the credit spread. The more credit risk in a bond, the more important the macroeconomic environment, while the value of investment grade corporate bonds, which have less credit risk, will be more influenced by the government bond yield.

For the past 12 months, credit spreads have been reasonably stable. They have continued to tick marginally lower in 2024 as it has become increasingly clear that the major economies will experience a soft landing. The US economy has proved remarkably resilient, and even the UK and Europe have emerged swiftly from their weakness at the end of 2023.

Volatility in government bond markets

At the start of the year bond markets were anticipating imminent rate cuts in the UK, Europe and US, prompted by optimistic Federal Reserve forecasts at the end of 2023. The US 10 year bond yield dipped as low as 3.8% in December*. Higher inflation figures, particularly in the US, have put an end to this rate cut optimism.

As a result, expectations of interest rate cuts have been pushed out. In the US, the central expectation is that there will still be rate cuts by the end of the year, but there is a plausible scenario that there will be no rate cuts at all this year as inflation remains persistently high and the economy remains strong.

Listen to more: David Coombs, manager of the Rathbone Strategic Growth Portfolio, gives his view on inflation and rate cuts in a recent interview.

Expectations for the UK and Europe have diverged. In Europe, for example, bond fund managers continue to expect rate cuts. The fixed income team at Invesco, which manages the Invesco Corporate Bond fund, says: “We believe the European Central Bank will cut interest rates more sharply than the market anticipates as inflationary pressures recede further in the coming months.”

They also believe that the Bank of England will cut rates: “We maintain our overweight allocation to UK interest rates. Higher than expected inflation and wage data sent yields higher in April, but the overall macroeconomic outlook remains one of below-trend growth and decelerating inflation, meaning rate cuts may be delayed but not precluded.”

Bryn Jones of the Rathbone Ethical Bond fund agrees, saying markets had got too excited about the prospect of a June cut prior to the recent inflation data. “Too many have been banking on the UK inflation rate getting back to the 2% target, but sticky inflation caused havoc once again. A large drop in CPI had been expected but to 2.1% not 2.3%….with 12% household energy price drops the main proponent of the drop.” Services inflation remains the sticking point, but the consensus is it should ease sufficiently to allow for a cut in September. The IMF continues to suggest there will be three rate cuts in the UK this year**.

Investment grade versus high yield

This should continue to be a solid backdrop for bond markets generally. It will favour investment grade bonds, which are more sensitive to rate cuts, over higher yield bonds, and Europe and the UK over the US. In the meantime, investors are paid to wait, with yields on corporate bonds still relatively high.

Richard Woolnough, manager of the M&G Strategic Corporate Bond and Corporate Bond funds, is retaining some sensitivity to changes in interest rates across both portfolios, believing that the environment is likely to be weaker than people expect. He says the full impact of interest rate hikes takes time to materialise. He also has a below-benchmark positioning in spread duration (sensitivity to changes in creditworthiness)***. This also suggests some pessimism about the economic environment.

He adds: “Despite the recent favourable movements in government bond yields, we believe there is still potential for yields to fall in an environment of lower inflation and subdued economic growth.”

Bryn Jones says that other factors may also favour government bonds, particularly high demand from investors and attractive yields. Inflation is falling and is likely to remain lower, so investors looking for a positive real yield and portfolio insurance can find both in the bond market. Like Richard (Woolnough), he believes that higher rates may not yet be fully reflected in the economic data and it remains a vulnerable moment for the global economy.

Against this backdrop, Bryn believes there could be a spike in default rates and is therefore being careful on credit risk. His focus in the fund is on non-cyclical areas, systemically important banks and insurers and he prefers investment grade over high yield.

There are concerns about the ‘maturity wall’ in high yield. A significant number of high yield issuers refinanced at low yields in 2020-2021. Those bonds are now coming to an end, and as much as half the high yield market will need to refinance in 2025 and 2026. Inevitably this will be at much higher rates and could create some distress for companies****.

The message on corporate bonds is still the same. There are opportunities, the yields are high, they are a good way to diversify a portfolio. However, at a time of economic vulnerability and with a maturity wall looming, careful credit selection is important. Investors need to be with a capable manager.

In addition to the managers mentioned above, we also like the BlackRock Corporate Bond fund, run by Ben Edwards, which invests predominantly in investment grade corporate bonds. Ben has built a strong track record of consistently exploiting inefficiencies in the fixed income market.

A fall in interest rates, when it comes, should be good for corporate bonds, particularly at the higher quality end. At the same time, high yields mean investors have a relatively large margin of safety. That said, spread levels are low and could widen out if there is any distress in the economic environment. Investors need to exercise caution.

*Source: MarketWatch, at 20 December 2023

**Source: BBC, 21 May 2024

***Source: fund commentary, May 2024

****Source: S&P Global, 5 February 2024