Horizon Q3│2023 - Bonds

Bond markets continue to offer return opportunities

Prof Dr Bernd Meyer and team provide an outlook for the 3rd quarter of 2023 in the current Horizon publication.

In a nutshell

  • Safe government bonds offer greater return opportunities in the US and the UK than in Germany.

  • In European corporate bonds, we prefer short-dated securities from the investment grade segment.

  • In emerging markets, local currency bonds remain our clear favourites.

Bonds remain (selectively) interesting also in the second half-year

After the upheavals surrounding Silicon Valley Bank and Credit Suisse in March, the dispute over the US debt ceiling was once again a central topic that affected all segments of the bond market in recent weeks. Ongoing recession concerns and inflation rates that are still well above the levels targeted by the central banks are also providing partly contradictory signals. In the following sections, we show where we see opportunities for returns in this situation.

Government bonds in local currency outside euro area more attractive

The yields of sovereigns with strong credit ratings mostly moved upwards in the second quarter, but there were no relevant price gains to be made. UK gilts have even shown a negative development since the beginning of the year (see figure below). The major central banks delivered no surprises recently – the European Central Bank raised its key interest rates, the US Fed paused. In the euro area, further increases in key interest rates on the one hand and recession concerns on the other will work in opposite directions, while in the US a rate hike is also expected initially, but this could be followed by a first cut as early as December. We expect both UK and US government bonds to outperform German Bunds in local currency terms. Against the background of economic risks, issuers with high credit ratings, even with longer maturities, are interesting for hedging in the overall portfolio context. We have therefore increased our interest rate duration to an almost neutral weighting, while we remain cautious in regards to risk premiums ("spread duration") in view of possible widening.

Safe government bonds: Outlook for Bunds weakest

Past and expected performance of 10-year government bonds, total effect of yield/price change, coupon yield and roll-down effect

Time period: 15/06/2018–15/06/2023
Source: Bloomberg, own calculations, iBoxx government bond indices (7-10 years, TR)

Forecasts: Key interest rates and government bond yields (in %)

Berenberg and consensus forecast in comparison, values at year-end 2023 and mid-year 2024

* Average, consensus as of 15/06/2023
Source: Bloomberg

Corporate bonds: boringly good

Sometimes boredom can be a good thing: European corporate bonds in the investment grade segment rose by +0.9% and high yield by +1.1% in the second quarter, with risk premiums remaining almost unchanged and thus still very attractive. The picture in the financial sector was different: although European banks posted solid quarterly results despite recession worries and real estate market stress, the fear stemming from the US banking sector could not be shaken off. Risk premiums over non-financial bonds also widened noticeably in the euro area (see chart below). Looking ahead, solid credit metrics, very active new issuance amid brisk demand, and moderate inflows into European corporate bond funds should continue to be supportive. A surprisingly positive rating trend in the investment grade segment and so far only minor defaults in high yields add to this. In view of a possible economic downturn, upward pressure on corporate interest costs and already adequate yields in the investment grade segment, we prefer this sector to investments in high yield. Although financial bonds and especially banks are tempting us with unusually high risk premiums, we remain cautious here as well in view of the problems in the US banking sector and focus on the systemically important major European banks. If the yield curves continue to be inverted, we will remain short in maturity in order to capture the higher yields and avoid excessive credit risks in the event of economic weakness. However, as soon as there are signs of a turnaround in the central banks' interest rate policy, we would prefer medium to longer maturities.

Euro financial bonds with clear risk premium edge

Risk premiums of financial versus non-financial bonds have widened significantly amid concerns in the banking sector

Time period: 01/06/2018–13/06/2023
Source: Bloomberg, own calculations

Emerging market bonds: local currencies still favourite

The homogeneous development of emerging market bonds from the beginning of the year came to an end in the second quarter. While the local currency segment developed positively, especially since May, government and corporate securities in hard currencies came under pressure over time. This was due to rising US yields and a revived US dollar. Falling inflation figures coupled with positive real interest rates, especially in Latin America, were and are the fundamental drivers for the outperformance of the local currency segment. Technical factors – such as still manageable investor positioning – support this development, and we expect the divergence in favour of the local currency segment to continue in the second half of the year. Local yields, which have already risen sharply, offer an attractive current yield compared to hard currency bonds at a lower duration. The high volatility in the US government bond market, which we expect to continue in the third quarter, makes an investment in local currency securities equally attractive from a risk perspective. In addition, core inflation rates in Europe and the US remain at a high level – if the interest rate increase cycles in the emerging markets run out faster than in the US and Europe, price performance will become more important again in addition to current interest rates. Therefore, in the course of the second half of the year, a gradual increase in duration in the market for local currency bonds seems opportune to us in order to also participate in this development.

Local currency securities in emerging markets pick up speed

Homogeneity between hard and local currency bonds (HC, LC) came to an end in May – we expect the latter to continue to perform stronger

Time period: 02/01/2023-13/06/2023, indexed to 100 as of 02/01/2023
Source: Bloomberg, own calculations

Conclusion: Uncertainties exist, opportunities remain

Interest rate policy, fears of a downturn, falling but still too high inflation – these and other risks exist, but we also see opportunities to continue earning money with bonds. Safe government bonds are more interesting beyond the euro area, but only in local currency, as currency uncertainty must be taken into account, especially in the case of US securities. The corporate bond segment is our favourite – we focus on good credit ratings with short maturities and avoid high-yield paper as well as banks outside systemically important large institutions. In emerging markets, we continue to prefer local currency investments, whereby a gradual increase in duration in expiring interest rate hike cycles in the second half of the year makes them even more attractive.


Martin Mayer
Senior Portfolio Manager Multi Asset
Christian Bettinger
Head of Fixed Income Euro & Emerging Markets