Horizon Q4│2023 - Bonds

In a nutshell

High-rated government bonds promise positive returns, in local currencies especially in the Anglo-Saxon region.
We like European corporate bonds defensively; at the short end, secure covered bonds offer similar yields.
In emerging markets, we favour the local currency segment and see corporate bonds in the lead.

Still good opportunities in an exciting environment

The lowering of the US credit rating from AAA to AA+ by the rating agency Fitch had a knock-on effect on the bond market at the beginning of August. Since Standard & Poor's has been awarding this (second-best) rating since 2011, the US Treasury is now only awarded the highest credit rating by Moody's among the major agencies. In addition, fears of recession and inflation continue to be important topics, although no clear signals have yet emerged in either area. Global key interest rate prospects and adequate yield levels, on the other hand, generally give reason for confidence.

Safe government bonds: Look ahead — land in sight

Yields of sovereigns with strong credit ratings rose for a long time in the third quarter as well, with UK gilts in the 10-year segment developing positively in contrast to German and US securities. Since the beginning of the year, however, they have performed the weakest in a comparison of the three currency areas (see figure below left). The European Central Bank raised its key interest rate by a total of 50 basis points in July and September, the US Fed in July and the Bank of England in August by 25 basis points each. In the US and the euro area, the phase of interest rate hikes is thus likely to be behind us. Our economists expect the BoE to leave the key interest rate at 5.25% until a first cut in Q2 2024. In the coming year, all three central banks are likely to turn the interest rate screw in the opposite direction. For 2024, the combination of expected yield movements and current interest offers an overall positive return perspective. Despite the higher supply of US Treasuries, US and UK government bonds were ahead of German Bunds in local currency until the middle of the year.

Grafik Bonds 1 EN — Time period: 22/09/2018–22/09/2023

Corporate bonds: It doesn't always have to be full throttle

Who would have thought? Despite the threat of recession and persistently high inflation, the riskier European high-yield bonds (+6.6%) have clearly outperformed investment grade paper (+2.7%) so far this year. However, a look at the valuation shows that the risk premiums in the high-yield segment still seem just about fair in a long-term comparison. In the event of a recession, they would even be considered very ambitious. In contrast, the risk premiums in the investment grade segment are more attractive. With average yields of around 4.4%, we continue to prefer this more defensive variant of corporate bonds. Here, the vast majority of issuers continue to convince with solid balance sheets and generous liquidity reserves. In terms of sector selection, we concentrate on defensive industries and avoid cyclical ones such as chemicals. Financial bonds were able to noticeably reduce the underperformance they had built up since March compared to non-financial bonds. This positive trend as well as continued very robust quarterly results confirm our overweight in European banks and insurance companies. As long as interest rate volatility remains at high levels, we prefer short-dated bonds between one and three years. At the short end, AAA-rated covered bonds offer almost the same yields as lower AA-rated corporate bonds (see chart below left). Here it makes sense to take risk out of the portfolio and add collateralised Pfandbriefe instead.

Grafik Bonds 2 EN — Time of observation: 20/09/2023, AAA/AA = average ratings in the respective segment

Emerging markets: Tailwind for corporate bonds

Although risk premiums on emerging market government and corporate bonds in hard currencies have widened somewhat recently, they are still near their lows for the year (see chart below right). Currently, the total return on hard currency bonds is more influenced by the volatility of US yields than by changes in risk premiums. We expect activity in the primary markets for government securities to increase. The focus is likely to be on investment grade countries, as yields on lower quality issuers remain high. On the corporate side, we continue to see limited new supply, with 2023 recording the lowest level of monthly issuance compared to the past decade. This should give corporate bonds a tailwind over government bonds. Inflation rates are likely to have peaked in many emerging markets, which has priced in impending monetary easing and positive performance from interest rate duration in the local currency segment. Although the spread between local and US interest rates is expected to narrow further, emerging market bonds should withstand this factor as well as the recent appreciation of the US dollar. We prefer local currency securities to their hard currency counterparts and expect Latin America to outperform Asia, Eastern Europe, Africa and the Middle East at the regional level. In terms of credit quality, we consider the investment grade segment more attractive compared to high yield and accordingly prefer a more defensive positioning.

Grafik Bonds 3 EN — Time period: 01/01/2022-20/09/2023, left scale: spreads (in basis points), right scale: spread difference (in basis points).

Conclusion: Bonds continue to offer good opportunities

We also see interesting opportunities for the coming months in all the bond segments discussed. However, a distinction must be made. Safe government bonds are particularly attractive in the respective local currencies outside the euro area, and in European corporate bonds we focus on defensive versus cyclical sectors and on good credit ratings as well as short maturities, whereby the addition of covered bonds is recommended. We also prefer the investment grade segment in emerging markets, where local currency bonds and the corporate segment are to be preferred over the government segment. A closer look within the bond classes is worthwhile.