Market commentary bonds: Quo vadis, credit spreads?

Rear-view mirror: Core inflation above target levels

Inflation rates, which remain the dominant theme on both sides of the Atlantic, continued to fall in the first quarter. German inflation fell from 3.7% to 2.5% over the course of the first quarter, while US inflation fell from 3.4% to 3.2%. However, this decline is mainly due to volatile food and energy prices, while the rest, the so-called core inflation rate, remains well above the central banks’ target level.

Core inflation rates remain between 3% and 4%, with Germany even at the upper end of this range. The pace at which interest rates are falling has also slowed. In the US, it have even come to a complete halt. As a result, there are concerns that inflation will stabilise at a level above the central banks’ target corridor.

Downward trends in interest rates reverse while credit spreads rally

Concerns about persistently high inflation have led to a reassessment of central banks’ interest rate paths and hence yield curves.

What looked like the beginning of a downward trend in interest rates in Q4/2023 reversed in Q1/2024. Over the quarter, ten-year yields in Germany and the US rose by around 35 basis points, although they are still some way off the highs reached in October.

Credit spreads, on the other hand, continued their rally, which had already led to strong price gains in November and December. Global IG spreads ended the quarter 14 basis points lower at 1.01%, while euro IG spreads fell by as much as 23 basis points to 1.15%. Positive expectations about the economic outlook and the ability of central banks to prevent a noticeable economic slowdown contributed to the positive sentiment.

In addition to credit spreads, the chart also shows the current yields on the major IG credit indices. These are just under 3.75% for euro IG and just under 5% (before hedging costs) for global IG. The elevated yield level, which meets the requirements of many institutional investors, is one reason for the continued robust demand for corporate bonds and has supported the tightening of spreads in the market.

Looking ahead: Increased risk of higher inflation

In the meantime, market participants have become less confident that inflation rates will soon return to central banks’ target levels. The following factors increase the risk of higher inflation rates in the longer term:

• Inflation rates are no longer driven by energy and food prices. Instead, prices for services are rising and inflation threatens to become entrenched.
• The fragmentation of the world into different blocs increases logistics costs, sea and land trade routes become riskier. Sanctions also increase costs, especially for those who impose them.
• A global trend towards increased military spending has a negative impact on inflation rates.
• The US has an election in November. The current government has a strong incentive to maximise pre-election spending in a highly polarised country.
• Consolidation is unlikely after the US election. President Biden is presiding over the highest peacetime budget deficit (as a percentage of GDP) in US history, while his predecessor, ex-President Trump, was responsible for the second-highest. There was no mention of fiscal restraint on either side of the aisle during the campaign.
• A new Biden term is likely to see further deficits due to rising social and defence spending, and further sanctions with negative effects; a second Trump term is likely to see an increase in trade barriers (tariffs), sanctions against China in particular, and new deficits due to tax cuts.
• In Europe and Japan, there is a risk of further inflationary pressure from the wage side; recent wage increases have been high; workers are increasingly prepared to use strikes to enforce their demands, as the wave of strikes in Germany shows.

Markets are pricing out rate cuts while central banks are cautious

It is therefore not surprising that markets have started to price out rate cuts or to expect them further down the road. Central banks have become increasingly cautious about the speed and extent of rate cuts.

Figure 4 shows the Fed members’ assessment of the future path of interest rates. It shows the median estimate for the federal funds rate at the end of each calendar year. The chart shows the current assessment and the assessment three months ago.

As can be seen from the chart, the members of the FOMC have not adjusted their expectations for 2024 but have increased their expectations for the federal funds rate by one rate hike of 25 basis points in each of the following years. According to the latest dot plots, the federal funds rate (the upper bound of the interest rate corridor) will be 4% at the end of 2025 (previously 3.75%) and 3.25% at the end of 2026 (previously 3%). And while interest rate markets remain volatile, there is a creeping trend towards a prolonged period of higher interest rates.

Credit spreads are pricing a soft landing while US labour markets are revised lower

Credit spreads, especially in US IG credit, are pricing in a soft landing, which implies a decline in inflation rates without an accompanying recession. The risk of spread widening increases with each basis point of index decline, as the soft-landing scenario is uncertain. The absence of a significant decline in inflation (“no landing” scenario) is also likely to have a negative impact on credit spreads.

In this context, the strong US labour market is repeatedly cited as a supportive factor for the economy and spreads. But beneath the calm surface of the monthly reports, there are problems. Firstly, the published figures for non-farm payrolls have been gradually revised downwards by almost 500,000 jobs in recent months, as the following chart shows.

In mid-March, the Philadelphia Fed then estimated in its Early Benchmark Report that the official statistics had overestimated the number of newly created jobs for the first nine months of 2023 by around 800,000. ¹

Looking ahead, the question is how the economy will evolve and whether credit spreads will continue to rally or whether we will see a reversal with spreads rising in the near future. So how should market participants position themselves?

A factor perspective shows…

We look at this question of positioning through a factor lens by analysing which bonds are interesting from a factor perspective at the moment:

• Bonds with higher spreads and beta, which should benefit if the rally continues?
• Or more defensive bonds with lower spreads that should outperform if spreads widen?

The following chart shows the relative spread level as a z-score against its own history for the four systematic credit factors: carry, momentum, value and quality.

How we calculate the relative spreads by factors:

• An equally weighted bond portfolio is created monthly for each factor, consisting of the 20 % of bonds on the market with the highest exposure to the respective factor.
• The average spread is calculated for this portfolio and compared to the market spread. This ratio is used to calculate a z-score, which shows the relative spread levels of the top value, top carry, top momentum and top quality bonds.
• A value of 0 means that the relative spreads of the factor are at a historically average level, while positive (negative) values mean that bonds with above-average (below-average) spreads are currently particularly attractive from the perspective of the respective factor.

Key findings:

• With the exception of the momentum factor, the relative spreads of attractive bonds in the market are currently low. For the carry factor, this reflects a lower dispersion of credit spreads.
• In contrast, the value and quality factors show that the most attractive bonds from these perspectives are not in the highest-yielding names. More defensive issuers with medium or lower spreads appear to be more attractive.
• For the momentum factor, the relative spread is only slightly below its historical average, but as this factor tends to be more defensive than the market, momentum does not indicate the attractiveness of riskier bonds either.

Although market developments are uncertain and factor values can change daily, the factor view shows that the most attractive issues in the market currently have lower spreads on average and are therefore less risky than the market average.

Conclusion

While interest rate markets are starting to price out the aggressive rate cuts that were expected amid stubbornly high inflation, credit markets are still in mode. While a soft landing is priced into the market, there are several risk factors that could upset the market’s best-case scenario. A look at systematic credit factors shows that many factors currently favour more defensive bonds on average. The next few months will show whether rates or credit investors have read the situation better.

1. See early-benchmark-2023-q3-report.pdf (philadelphiafed.org) ↩︎