Short-dated credit: Why front-end yields are hard to ignore

The conflict in Iran has driven a sharp repricing at the front-end of rates markets, pushing central bank expectations from cuts to hikes in a matter of weeks. While the reaction is understandable given the inflationary impact, the scale of the move has left front-end yields on a more attractive footing.

The widening in Treasuries has been roughly matched in Gilts, despite the political uncertainty that has made Gilts particularly volatile over the past two months. Bunds have outperformed, reflecting the larger growth drag from higher energy prices in Europe. Underlying the move is a wholesale repricing of central bank expectations: pre-conflict, markets expected 57 basis points (bp) of cuts from the Federal Reserve (Fed), 52bp from the Bank of England (BoE) and 8bp from the European Central Bank (ECB); markets now price 22bp of hikes from the Fed, 47bp from the BoE and 66bp from the ECB by the end of the year. That is a substantial repricing in a short space of time, and in our view, the bulk of the front-end adjustment is behind us.

The distinction between this and post Covid inflation matters. That was a broad-based demand surge across almost every category as the economy reopened, labour markets were very tight, and wage inflation surged. The current situation is a one-off energy supply shock against a softer macro backdrop, with far less scope for a sustained inflation spiral. We therefore expect central banks to largely look through the discrete impact on energy costs. The Fed and the BoE remain above neutral and can afford to be patient; the ECB, currently at neutral, looks likely to deliver a precautionary hike in June. A near-term resolution to the conflict and a recovery in energy prices would give markets room to price out some of the rate hikes currently priced in the curve, consistent with central bank communication suggesting limited persistence in second-round effects.

For investors, the key point is that the repricing has meaningfully improved all-in yield. All-in levels on the 1-5-year investment grade (IG) index are now 4.73% in the US (53bp higher since the start of the conflict), 5.29% in the UK (+68bp) and 3.39% in Europe (+48bp). That is a meaningful step up and strengthens the case for short-dated credit.

With yields substantially higher, breakevens are now even more attractive, offering substantial downside protection. Index-level breakevens now sit around 250bp, meaning yields would need to rise by more than 250bp before annual returns turn negative.

Starting yield remains a powerful predictor of future returns. The recent repricing has lifted starting yields enough to move us from the 55th to the 64th percentile for three-year returns. On the Global 1-5-year IG index, the current yield of 4.23% points to an annual return of around 5.35%; through active management, we believe we can add roughly 100bp to both yield and three-year return, taking the return outlook to over 6%. 

Rates have done most of the work. The sell-off in credit spreads at the start of the conflict was short-lived and has largely reversed. That resilience is supported by corporate fundamentals: earnings are strong, balance sheets healthy, and much of the IG space is relatively insulated from the energy shock. Pricing power also remains intact in a higher inflationary environment. We are more cautious on issuers directly exposed to the Middle East or to energy-driven margin pressure, but for the index as a whole, the credit story remains constructive.

The technical picture reinforces the argument. The higher yields on offer are attracting strong fund flows, ensuring demand for credit is resilient, and allowing markets to absorb primary supply with ease. Absent a meaningful escalation in the conflict, it is hard to see what would push spreads meaningfully wider while the technical demand picture remains strong. Volatility along the way is to be expected, but at the front-end, it is materially dampened compared to the long end of the curve. In our view, investors are not being adequately compensated for the additional risk of moving further out the curve. Fiscal pressures are still elevated, leaving the long end exposed to term premium and heavy issuance pipelines we would rather not own.

The combination of high carry, deep downside protection from elevated breakevens and an attractive three-year return outlook of 6% is rare, and historically, yields at the front-end do not stay at these levels for long. Fundamentals are sound, technicals are strong, and the carry alone delivers an attractive return without needing rates or spreads to rally from here. With macroeconomic and geopolitical uncertainty expected to remain, short-dated IG credit, in our view, offers a very attractive return, and one that is not predicated on rate cuts or spread tightening, but on carry and roll-down alone.