After a challenging January, which saw markets beginning to come to terms with a very hawkish Fed pivot and rising Russia-Ukraine tensions, it is worth taking stock of the moves we have seen in fixed income over the last few weeks.
If we start with government bond curves, US Treasuries have moved aggressively as the Fed has continued with the hawkish shift it indicated late last year. As a result, markets are now pricing in just under five Fed rate hikes in 2022, up from just under three hikes at the start of the year (in addition to the beginning of quantitative tightening). Meanwhile, the two-year US Treasury yield started the year at 0.73% and is currently 1.30% (+57bp), while the 10-year yield has moved from 1.52% to 1.91% (+39bp), representing a bear curve flattening of 18bp.
Last Thursday, we also received hawkish signals from the Bank of England, with four out of nine monetary policy committee (MPC) members voting for a 50bp hike. As a result, 10-year Gilt yields started the year at 1% and are now around 40bp higher. Likewise, even though it is too soon for the ECB to hike, its rhetoric has become more hawkish, resulting in the 10-year Bund yield moving from -0.18% at the start of the year to its current 0.21%.
Given concerns surrounding inflation momentum and the resulting moves in government bond markets, we have not been surprised to see elevated volatility in credit markets. However, we had expected any underperformance to be most concentrated in those investment grade markets that are most correlated to the underlying rates moves, given their minimal spread cushions and greater sensitivity to duration than the lower rated high yield market.
Indeed, dollar and sterling investment grade corporate bonds have experienced steep losses, returning -4.2% and -5.2% respectively year-to-date, while dollar and sterling high yield indices have outperformed by 110bp and 284bp, returning -3.1% and -2.3% YTD. At -2.9% YTD, European IG has experienced more muted losses given the index is some three years shorter in duration than its dollar and sterling equivalents, though it has likewise underperformed the euro high yield index, which has returned -2.75% YTD.
While we acknowledge that credit spread widening could and probably does have a little further to run, we should remember that spreads have already made a reasonable move wider, especially given the solid fundamental backdrop.
For example, euro high yield spreads have widened by 45bp YTD to 376bp, which is 11bp wide of their five-year average, a period that includes both the COVID spike up to 866bp, and the 2018 peak of 528bp when yields widened due to fears of a looming end to the pre-COVID economic cycle. Given the underlying rates move over the last five weeks, on a yield basis we have moved even further, with the current yield-to-worst on the euro high yield index now at 3.75%. The yield on the euro HY index is now 56bp wide of its five-year average and only 25bp short of its 10-year average, a period that includes the Europe’s sovereign credit crisis when yields peaked above 10%.
However, record low default rates in Europe and the US continue to look supportive for credit, and they are forecast to remain well below long term averages for 2022 and 2023. Additionally, we expect the current positive ratings migration to continue at a historically rapid pace, economic growth is well above trend and the banking sector, in our view, is as strong as it has ever been.
Putting all this together, we think the current softness could continue in the short term, but the strong fundamentals should ultimately underpin the market. Timing is always important when trying to buy dips, and this dip is the most meaningful one we have seen since March 2020.