After 30 years of falling rates and 2 years of rising rates, what is the state of the bond market today?
Despite a number of disruptive events – the fall of the Berlin Wall, the 1994 bond crash, the Gulf War, the bursting of the dotcom bubble and the collapse of Lehman Brothers – long yields fell almost uninterrupted for more than 30 years between 1990 and 2020, before rising sharply between 2021 and 2023, wiping out almost 10 years of performance. Over these years, the market has undergone a profound transformation, helped by the growing indebtedness of governments. The scope of available instruments has widened. Limited to government debt in 1990, bank, corporate and private debt have since been added to the pool. The instruments have also become more sophisticated, with the arrival and growing importance of futures markets, structured products and, finally, synthetic products, fuelling an increasingly flourishing industry. Hedge funds, thematic funds, index funds, ETFs, total return funds, dated funds – each year brought its cohort of increasingly innovative products.
The only thing to remember about all this is that the long-term performance of a bond is based primarily on its carry and the short- and medium-term performance of the mark-to-market.
Today, after 4 lean years with a carry close to zero, the bond market has regained its credentials and its predominant place in an asset allocation portfolio.
High yield, investment grade, government bonds – what should you choose?
Today, the relatively low level and, above all, the inversion of the curve on quality sovereign issuers are factors that do not work in favour of government bonds. The strong rally in high yield and the HY index dropping below 300bp mean that we prefer BB-rated issuers to low-B issuers.
Our current preference is for BBB-rated IG bonds.
Why a flexible fund rather than an index fund or ETF?
As we have noted above, the bond toolbox is extremely extensive. Without using leverage or synthetic products, there is always an opportunity through the different types of instruments and strategies that can deliver performance. Furthermore, over the course of a year, there are between 2 and 3 fairly predictable market movements that are a source of alpha creation.
For this reason, a flexible fund will always be preferable to an ETF or an index fund.
What is the outlook for Fed and ECB monetary policy in the short and medium term?
Our central scenario is based on the conviction that the sharp rise in key rates that we have just seen, even if it came as a surprise because of its speed, is merely a normalisation and that there is no excess in the levels reached, either for Fed Funds at 5.50% or for the ECB’s refi rate at 4.50%. The peak has been reached, but the central bankers are going to pause for a moment.
However, we expect the ECB to make its first 25p cut in June and the Fed to make its first cut this autumn.
What is the outlook for the interest rate market?
We will soon be entering a phase of rate cuts. Even so, we think that on the long end of the curve, given its inversion, there could still be some tension. The levels of 2.50%, 2.75% and 3% on German 10-year yields are markers that will be used to increase the duration of the portfolio, and thus take full advantage of the coming decline.