Insight

Monthly fixed income update - April 2023

Invesco monthly gold update

Asset Class Returns

Compared to the volatility seen in March, which was caused by issues in the banking sector in both the US and Europe, April was a much calmer month for fixed income markets. Having rallied sharply in response to the collapse of Silicon Valley Bank in March, interest rate expectations drifted higher during April as the situation appeared to have been contained and the focus turned back to the economic outlook. However, while rate expectations rose, US and eurozone government bond yields were little changed over the month, although yields on UK government debt did underperform as inflation data remained stubbornly high.

However, the UK Gilt market performed poorly due to concerns that high inflation would require further rate hikes from the Bank of England Credit markets performed reasonably well as spreads were generally tighter having previously widened over concerns about the banking sector while the AT1 market stabilised following the sharp sell-off in the first half of March. 

Asset class returns
asset class returns

Source: Bloomberg, Invesco as at 30 Apr 2023

Government and Inflation-Linked Bonds

Government and inflation-linked bond markets in the US and eurozone were rangebound during April, ending the month at similar levels to those seen at the end of March. In the US, TIPS slightly underperformed conventional Treasuries as headline inflation was marginally lower than market expectations, but returns for both asset classes were subdued following the strong performance in March. The UK Gilt market performed poorly, however, due to concerns that high inflation would require further rate hikes from the Bank of England.

US Rates

The yield on the benchmark 10-year US Treasury ended the month just 5 basis points (bps) lower than at the end of March, having traded in a relatively tight range during the month. Similarly, the shape of the yield curve was also relatively stable over the month given the lack of directionality. However, as headline inflation was slightly lower than expected, falling to 5.0% (the lowest level since May 2021), breakeven inflation rates were slightly narrower over the month, with the TIPS market underperforming Treasuries. While the medium-term outlook for Treasuries will depend on the outlook for inflation and Federal Reserve policy, in the near-term, concerns about the debt ceiling are starting to impact yields in very short-dated Treasuries and T-bills; particularly those that mature in early June as that is the likely date the US would run into debt-ceiling limitations without a resolution. 

US rates
us rates

Source: Bloomberg, Invesco as at 30 Apr 2023

Eurozone Rates

Like US Treasuries, it was a quiet month for Eurozone government bonds. Yields were rangebound in both core and peripheral bond markets and the shapes of yield curves were little changed. However, as eurozone inflation was in line with expectations, it had little effect on breakeven inflation rates with performance in both nominal and inflation-linked eurozone government bonds close to zero for the month.

Eurozone rates
Eurozone rates

Source: Bloomberg, Invesco as at 30 Apr 2023

UK Rates

The gilt market was the outlier in April, underperforming its US and eurozone counterparts in both nominal and inflation-linked markets. 10-year gilt yields rose by 23bps while 10-year index-linked gilt real yields rose by 41bps, and the sell-off was largely caused by buoyant economic data. In particular, strong wage growth and inflation falling by much less than had been expected and remaining above 10%, drove rate expectations higher during the month. However, the high real yield on offer led to record demand for a new 30-year index-linked gilt towards month-end in which the syndicated issued received £46 billion in bids for an issue size of £4.5 billion. 

UK rates
UK rates

Source: Bloomberg, Invesco as at 30 Apr 2023

Keep an eye on…

...central bank policy and the outlook for inflation.

Investment Grade Credit

Investment grade credit spreads started tightening in the second half of March, having previously widened over concerns about the banking sector. This spread tightening continued in April, with GBP-denominated credit performing particularly well in spread terms, largely due to the upward pressure on gilt yields. On the other hand, spread tightening for USD credit was limited as Treasury yields were also slightly lower during the month. Nevertheless, market sentiment for investment grade credit generally remains positive with the asset class seeing strong inflows over the month.

Investment Grade Credit
Investment Grade Credit

Source: Bloomberg, Invesco as at 30 Apr 2023

Keep an eye on…

…banks and whether lending standards are tightened

High Yield and Subordinated Credit

The movement in spreads in both high yield and subordinated credit was relatively subdued in April. However, considering the magnitude of the Credit Suisse news in March, the stability of the AT1 market during April can be viewed as a broadly positive outcome for the asset class with spreads tightening modestly over the month. Overall, while they remain at relatively wide levels, AT1 spreads have bounced from the distressed levels seen in the middle of March and are back within the range that has been seen before during previous market downturns.

High Yield and Subordinated Credit
High Yield and Subordinated Credit

Source: Bloomberg, Invesco as at 30 Apr 2023

Keep an eye on…

…AT1 market performance, which is likely to drive risk appetite

Fixed Income ETF Flows

Fixed income ETFs had another strong month with net inflows of $7.2 billion and taking year-to-date NNA to $23.5 billion. There were further signs of an investor preference for higher quality fixed income, likely due to concerns about the banking sector, with government and investment grade credit occupying several spaces in the top categories for inflows and accounting for over 90% of NNA in April. However, there were also some early signs of investors looking to add risk with high yield also seeing a reasonable level of demand following spreads widening in March. While there were few categories that saw material outflows, inflation remains out of favour.

Top and Bottom 5 Fixed Income ETF Categories in April 2023
Top and Bottom 5 Fixed Income ETF Categories in April 2023

Source: Bloomberg, Invesco as at 30 Apr 2023

What’s Next?

  • Recent stimulus, and the race to “Net-Zero”(cutting greenhouse gas emissions to as close to zero as possible) spurring $8 Trillion a year of additional spending on materials globally is likely to have a material impact on inflation in the coming years. Baseline inflation forecasts assume flat commodity prices, in our view often underestimating future inflation given the green transitions’ likely impact on supply and demand dynamics. Specifically, the supply constraint in oil, gas and coal production before the supply of low carbon energy alternatives that are readily available are creating an energy supply constraint, whilst demand continues to grow. Thus, we believe that commodity price inflation will support a higher level of US CPI and that actual inflation will print much higher than break evens are pricing today.
  • We expect real rates, defined as nominal Treasury Yields minus actual CPI, will continue to rise in a quantitative tightening world, and will spur bond investors to demand a positive real yield on intermediate and longer duration treasuries—that is, a positive real yield based on the factual inflation trend (rather than the inflation rate implied by the TIPS breakeven rate).

For most of the past 15 years, 2 year TIPs(Treasury Inflation-Protected Securities) have meaningfully underpriced actual CPI trends.

Past performance is not a guarentee of future results

  • If the Federal Reserve hits the pause button on rate hikes this summer, we believe the market is underestimating the risk of a bear steepening if economic growth or inflation proves resilient in 2023. As such, we believe there may be a better time later this year to strategically add to intermediate, and eventually, longer duration, high quality credit. 

How to position?

For cash management allocations, we remain constructive on short duration, high quality bonds such as US Treasuries and Munis. Given the rise in front-end interest rates this year, we believe the risk/reward skews in favor of US Treasury and Muni bonds with minimal duration to help capture potential higher yields and provide limited sensitivity to interest rate volatility.

Additionally, in lieu of traditional core bond funds, hold-to-maturity strategies like defined maturity ETFs can help mitigate interest rate volatility and provide investors with greater predictability on potential future portfolio returns. Laddering out a series of defined maturity ETFs can provide investors with a targeted portfolio duration and better visibility on potential total return relative to a traditional bond fund. We think that adding investment grade corporate bond ladders to portfolio can be another way to manage interest rate volatility in the current environment. 

Short Duration Treasuries

  • 3 month T-Bills started 2022 yielding roughly 0.09% and have increased 493bps to 5.02% as of the end of April 2023
  • Very short duration US Treasuries can provide investors with a historically high yield to park cash in the near-term and potentially insulate from volatile interest rate movements

Muni Money Market Securities (VRDO’s)

  • Variable Rate Demand Obligations (VRDO’s) are high quality floating rate muni securities that typically have coupons that reset weekly based on the SIFMA(Securities Industry and Financial Markets Association) Municipal Swap Index Yield
  • The current yield on the SIFMA Swap Index is 3.45% as of 05/03/2023, or over 5.7% on a taxable equivalent yield for investors in the highest tax bracket

Investment Grade Corporate Bond Ladders

  • Short to intermediate Investment Grade Corporate bond yields are at historically attractive levels(the highest since 2009) with yields still remaining near 4.7% across the curve
  • Laddering Investment Grade Corporate bonds provides investors with balance across the curve, while providing continuous yearly liquidity for reinvestment in potential higher yielding bonds should US rates continue to increase
  • By laddering bonds and holding them to maturity, investors can potentially mitigate interest rate risk and add greater visibility on future returns over a given time period

Short-Term TIPs

  • Breakeven inflation rates may be underappreciating the possible inflation pressures in the near-term, as outlined in the above graph.
  • Short-term TIPs (up to 5 years maturity) may provide relative value to US Treasuries as a hedge should inflation overshoot expectations

Investment risks

  • The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

Important information

This document is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication.

Data as at 30 April 2023, unless otherwise stated

 Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals, they are subject to change without notice and are not to be construed as investment advice.