Insight

Monthly fixed income update - December 2022

Invesco monthly gold update

Asset Class Returns

Additional tier 1 capital bonds were the star performer in an otherwise lacklustre month for fixed income returns. The Federal Reserve, European Central Bank and Bank of England all hiked rates by 0.5% in December. However, as that had been widely expected, it was the accompanying statements that had the greatest impact on market direction. While none offered a particularly dovish spin, the European Central Bank was perceived as the most hawkish of the three due to their substantial upward revision to the inflation outlook and requirement for significantly higher rates to bring it back to target. Combined with the announcement they would start unwinding their bond portfolio from the earlier quantitative easing purchases, this caused eurozone government bond yields to rise the most in December.

Asset class returns

Source: Bloomberg, Invesco as at 31 Dec 2022

Government and Inflation-Linked Bonds

Government and inflation-linked bond yields rose during December as central banks continued tightening monetary policy to bring inflation back to target but, with each bank hiking by 0.5%, the pace of tightening was slower than the 0.75% hikes that have been delivered in recent months.  So far this cycle, the Federal Reserve have acted most aggressively which seems to be having the desired effect as the annual rate of inflation (as measured by headline CPI) has fallen by 2% to 7.1%, since the middle of the year.  However, in both the eurozone and the UK, inflation only appears to be peaking now and remains in double digits.  Nevertheless, the hawkish central bank rhetoric did cause breakeven inflation rates to narrow over the month and inflation-linked bonds to underperform.

US Rates

US Treasuries continued to rally in early December, but yields rose following the Federal Reserve rate decision and press conference.  Although the 0.5% hike to 4.5% was in line with market expectations, both the forecast for inflation and the projection for base rates were raised, with Chairman Powell indicating that monetary policy would need to remain tight for some time to bring inflation down.  The benchmark 10-year Treasury yield rose by 27 basis points over the month to end the year at 3.87%.  For a second consecutive month, inflation data was lower than market expectations which, combined with a hawkish Fed, caused breakeven inflation rates to fall and the yield on the 10-year Treasury Inflation Protected Security (TIPS) to rise by 33 basis points. 

Looking back at 2022, the 236bp rise in 10-year Treasury yields is the biggest calendar year increase since the inception of generic yield data 60 years ago while the 267bp rise in 10-year TIPS real yields is the largest rise since the US started issuing inflation-linked bonds in 1997. 

US rates

Source: Bloomberg, Invesco as at 31 Dec 2022

Eurozone Rates

Eurozone government bond yields were driven higher by the hawkish announcements in the European Central Bank’s (ECB) December meeting.  Like the Federal Reserve, the ECB delivered the expected 50 basis point rate hike.  However, the accompanying statement was considerably more hawkish than the previous one, stating that the outlook for inflation had been substantially revised upward and that interest rates would need to rise significantly to sufficiently restrictive levels to return inflation to target. The ECB also announced that they would start reducing their asset purchase programme holdings from March 2023 onwards, initially by not fully reinvesting all proceeds from bonds that mature. 

While these announcements caused a sharp rise in core eurozone government bond yields (10-year German yields rose by 64 basis points in December to end the year at 2.57%), the bigger impact was on peripheral markets with Italian 10-year yields rising by 84 basis points and closing the year at 4.72%.  Like US Treasuries, 2022 saw the largest calendar year rise in 10-year German yields in the 30 years since generic data has been available.

Eurozone rates

Source: Bloomberg, Invesco as at 31 Dec 2022

UK Rates

While the Bank of England hiked rates by the expected 50 basis points, there was an unusual three-way split by the committee with six members voting for the 0.5% hike, one voting for a more aggressive 0.75% hike and two members preferring to leave rates unchanged.  Over the month, 10-year gilt yields rose by 51 basis points while 10-year index-linked gilts real yields rose by 67 basis points to end the year at 3.67% and 0.06% respectively.  Both gilts (+270 basis points) and index-linked gilts (+303 basis points) were further core government and inflation-linked markets that saw a record calendar year yield rises.

UK rates

Source: Bloomberg, Invesco as at 31 Dec 2022 

Keep an eye on…

  • Inflation data – central bank policy is being dictated by the currently high levels of inflation but there is a fine line between tightening policy enough to bring inflation under control and tightening too much and driving the economy into recession with central banks having to decide when to enact a policy pivot following aggressive rate hikes in 2022.trol.
     

Investment Grade Credit

Although the rise in government bond yields meant that investment grade credit returns were negative in December, further spread tightening led to credit markets outperforming government bonds.  Investment grade credit ETFs continued to see strong demand in December, taking in $1.6Bn and accounting for over 60% of net new assets over the month.  EUR-denominated credit once again led the way in terms of spreads tightening (-14bps), followed by GBP-denominated -12bps) while USD credit lagged (-2bps) which is perhaps unsurprising given it’s trading at much tighter levels.ively earlier in the year.

Investment grade credit

Source: Bloomberg, Invesco as at 31 Dec 2022

Keep an eye on…

  • The likelihood of recession – while spreads for EUR and GBP-denominated credit remain wide even after the recent bounce, USD-denominated credit spreads are close to longer term averages and could be vulnerable if the Fed are unable to generate a “soft landing” for the economy.

High Yield and Subordinated Credit

Lower rated credit markets generally performed well in terms of spread tightening, except for USD-denominated high yield.  However, with risk-free rates rising, only USD-denominated AT1s could provide a positive return in December. 

Over the month, spreads on EUR-denominated high yield tightened by 14bps while on USD-denominated high yield spreads widened by 21bps, with the different direction potentially being caused by USD spreads already trading at tight levels relative to EUR spreads.  Spreads on both Euro corporate hybrids (-20bps) and USD AT1s (-34bps) tightened in December but remain wide relative to longer term averages. 

High yield and subordinated credit

Source: Bloomberg, Invesco as at 31 Dec 2022

Keep an eye on…

  • Relative value between subordinated and traditional high yield markets with the former continuing to look attractive based on historic levels.

Fixed Income ETF Flows

Although considerably slower than November, net inflows into fixed income ETFs remained robust at $2.6Bn and took total net new assets for 2022 to $32.7Bn.

US Treasuries (+$1.0Bn) returned to the top spot in December, although inflows broadly favoured shorter-maturity ETFs.  EUR-denominated credit (+$0.9Bn) came second, followed by aggregate (+0.8Bn), high yield (+0.7Bn) and a second consecutive strong month for EM government bonds (+0.5Bn).

EUR government bonds (-$1.3Bn) led the outflows followed by another poor month for China Bonds (-$0.5Bn).  Cash management (-$0.4Bn), floating rate (-$0.3Bn) and inverse (-$0.2Bn) complete the top five for outflows.

5 top and bottom fixed income ETF categories in November

Source: Bloomberg, Invesco, as at 31 Dec 2022.

For the whole of 2022, the theme seen from fixed income ETF flows was very much one of moving higher in quality.  This is largely unsurprising as previous flows into lower rated bonds was largely driven by the extremely low yields offered by developed market government and investment grade bonds, particularly since the pandemic.  However, following central banks tightening policy, these higher quality, more liquid fixed income asset classes now offer sufficient yield to attract demand once more.

US Treasuries (+20.0Bn) came in first place by some margin for the year, accounting for 61% of net new fixed income assets over the year.  EUR- and USD-denominated investment grade credit came in second and third spot with $8.4Bn and $7.8Bn of net new assets respectively.  EUR governments were in fourth place with $6.5Bn of inflows.  In total, developed market government bond ETFs accounted for almost $29Bn (89%) of net inflows over the year.

China Bond (-$11.3Bn) dominated the outflows as yields fell below those on developed market government bonds.  Inflation (-$5.1Bn) had a poor year as central banks tightened policy as did lower quality credit (high yield -$2.6Bn and fallen angels -$0.9Bn).  Inverse ETFs – those betting on rising yields – also saw significant outflows as the rise in yields generated positive returns.

Top and Bottom 5 Fixed Income ETF Categories in 2022

Source: Bloomberg, Invesco, as at 29 Nov 2022.

What's Next?

  • Recent stimulus, and the race to “Net-Zero” 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 have meaningfully underpriced actual CPI trends.

Source: Bloomberg LP, Past performance is not a guarantee of future results.

  • As the Federal Reserve hits the pause button on rate hikes this spring, 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 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 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 422bps YTD to 4.31%
  • 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 Swap Index Yield
  • The current yield on the SIFMA Swap Index is 1.85%, or over 3% on a taxable equivalent yield for investors in the highest tax bracket

Investment Grade Corporate Bond Ladders

  • Investment Grade Corporate bond yields are at historically attractive levels with yields briefly exceeding 6% in October*
  • Laddering Investment Grade Corporate bonds provides investors with balance across the curve, while providing continuous yearly liquidity for reinvestment in 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 graph on What's Next section.
  • Short-term TIPs (up to 5 years maturity) may provide relative value to US Treasuries as a hedge should inflation overshoot expectations
     

*Source: Bloomberg LP, Past performance does not guarantee future results.

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.