On the face of it, fixed income has much to recommend it at present: yields are at levels not seen since 2007, default rates remain low and bonds once again provide real diversification within a portfolio. At the same time, falling interest rates and inflation should be good news for yields while a ‘soft’ economic landing ought to keep defaults in check.
And investors would appear to have recognised the opportunity. According to fund tracker EPFR, a record $22.8bn (£18.2bn) has flowed into US corporate bond markets over the year to date – the strongest annual start in five years. In the UK, corporate bonds were the second best-selling retail sector in January (after money market funds).
That said, fixed income performance since the start of the year has been relatively weak, suggesting the outlook may be more nuanced, and there are a range of factors that could destabilise bond markets in the near term. First and foremost is shifting expectations on interest rates. At the start of the year, it became increasingly clear the expectations for rate cuts in 2024 were too high. Government bond yields had fallen too far, given the likely trajectory of inflation.
“This caused a huge amount of easing in financial conditions,” says James Ringer, a fixed income portfolio manager at Schroders.
“This is one of the better leading indicators of where growth will follow and the impact can be relatively swift. We came into 2024 revising down the probability of a hard landing significantly and started revising up the probability of no landing.” This re-adjustment of rate expectations has been a major driver of the weakness in bond markets since the start of the year.
US debt levels
While that adjustment is now complete, there are other factors that may exert a longer-term influence on fixed-income markets. The level of US debt, for example, is a risk factor. The US fiscal deficit in 2023 was $1.7trn, an increase of $320bn from the previous fiscal year. For the year to date, the Federal government has spent $828bn more than it has collected in taxes. On current rates, the government will be spending one-third of its income on debt interest by 2030.
On most measures, this looks unsustainable – yet neither presidential candidate appears inclined to tackle it. Donald Trump is pushing for tax cuts, while Joe Biden would like more spending. Historically, the US government has been able to rely on a range of buyers for its debt, but some of these natural buyers are evaporating. At the same time, the US Federal Reserve has withdrawn support for fixed-income markets through its quantitative tightening programme – now manifesting as strains in the reverse repo market.
Historically, as and when domestic interest went cold, the US could rely on international buyers to absorb its debt – but there have been changes here as well. The Japanese, for example, have been strong buyers of US debt but, as the Bank of Japan raises domestic interest rates, there are signs they are turning back to their local market. There are also risks around geopolitics – China has historically been a significant buyer of US debt, but deteriorating relations between the two sides makes this less likely.
The real question, of course, is not whether there are buyers for US debt so much as the price they are willing to pay. Phillip Swagel, director of the Congressional Budget Office, has suggested the mounting US fiscal burden is on an “unprecedented” trajectory, risking a crisis akin to the Liz Truss/Kwasi Kwarteng moment in the UK.
While there has been plenty of speculation, however, such a crisis would not appear imminent. Spending on largescale infrastructure and green energy projects will ease, and the US may end up issuing a smaller amount of net debt than last year.
Furthermore, if there are any signs of strain in the market, the Federal Reserve is likely to slow its quantitative tightening programme, which would slow the supply of US treasuries hitting the market. Money market funds are also likely to be a significant source of demand so this should remain a risk about which investors need to be vigilant, rather than a source of immediate problems.
Read the rest of this article in the April issue of Portfolio Adviser magazine
