Monthly fixed income update - January 2023

Fixed income: credit markets led the way in January
January was a broadly positive month for financial markets with both bonds and equities rallying. Within fixed income, credit markets led the way as lower rated bonds outperformed higher rated bonds, in line with the “risk-on” tone from equity markets. However, high quality government and inflation-linked bonds also produced solid returns as confidence grew that central banks would slow the pace of rate hikes in coming months which, with peak rates potentially now in sight, could lead to the soft landing that would be positive for many asset classes.
Source: Bloomberg, Invesco as at 31 Jan 2023
Government and Inflation-Linked Bonds
Government and inflation-linked bond yields rallied strongly in January in a relatively quiet month for Central Bank announcements and policy decisions. Further evidence of the risk-on tone was seen in the eurozone where peripheral government bonds rallied more strongly than core government bonds. The annual rate of inflation declined in the US, eurozone and the UK which, while broadly in line with expectations, maybe partly responsible for the fall in breakeven inflation rates, particularly in the UK and eurozone.
US Rates
US Treasuries rallied in January with 10-year yields ending the month 37bp lower to close the month at 3.51%. Although the Federal Reserve did slow the pace of tightening as expected in their meeting at the beginning of February, expectations of further interest rates hikes have prevented short-dated Treasuries from rallying as much as longer-dated Treasuries. Having steepened in December, the rally caused the spread between 2-year and 10-year Treasuries to become more inverted in January. TIPS lagged as often happens in directional markets, with the continued decline in the inflation rate pressuring breakeven inflation rates, but the 10-year still rallied by a healthy 31bp on the month.
Source: Bloomberg, Invesco as at 31 Jan 2023
Eurozone Rates
Eurozone government bond yields also performed well in January. While 10-year German government bonds rallied by 13bp, it was peripheral eurozone bonds that led the way, with 10-year Italian government bonds ending the month 56bp lower in yield. Although Italy gave back some ground towards the end of the month, the rally did cause the spread between German and Italian 10-year government bonds to touch 1.7% in the middle of January, the tightest that spread has been since April 2022.
Source: Bloomberg, Invesco as at 31 Jan 2023
UK Rates
Like other developed government bond markets, 10-year gilts rallied strongly with yield ending the month 34bp lower. Index-linked gilts lagged in yield terms, only rallying by 12bp as breakeven inflation rates fell. However, due to its higher interest rate risk, the index-linked gilt market outperformed conventional gilts in total return terms.
Source: Bloomberg, Invesco as at 31 Jan 2023
Keep an eye on…
Central bank rhetoric – although the Federal Reserve, ECB, and Bank of England rate decisions at the start of February were in line with expectations, speeches from central bankers could provide valuable insights on the likely future path of interest rates with any signs that rates are close to peaking likely to spur a further rally.
Investment Grade Credit
Credit performed strongly in January, driven by both the rally in risk-free rates and the positive market tone driving spreads tighter. While USD and EUR-denominated credit yields rallied by 46bp and 36bp respectively, the GBP-denominated market was particularly strong over the month. Although there doesn’t appear to have been a specific catalyst, it’s possible that Sterling credit markets were still playing catch-up following the impact of the political shenanigans last year. Meanwhile, although EUR-denominated credit led ETF inflows and performed well, it lagged other markets, potentially due to having to absorb a large amount of supply during the month. Although GBP- and EUR- investment grade credit spreads remain wide of long-term average, at 117bp the USD-market now appears to be pricing in a particularly soft landing.
Source: Bloomberg, Invesco as at 31 Jan 2023
Keep an eye on…
The likelihood of recession – at current valuations, USD-denominated credit spreads could be vulnerable to a hawkish Federal Reserve or signs of a deeper economic downturn than the market is currently expecting.
High Yield and Subordinated Credit
Lower rated credit markets rallied hard in January, with spreads tightening as investors continued their return to high yield following the heavy selling seen last year until October. USD-denominated high yield rallied by 82bp with spreads tightening by almost 50bp. But it was USD-denominated AT1s that were the star performer as yields rallied by over 130bp. Following the uncertainty last year that caused investors to question whether rising yields would lead to existing AT1s not being called, the strong rally over the last few months, along with issuers continuing to call existing AT1s, has increased investor confidence in the market. EUR-denominated high yield and corporate hybrids yields rallied by 76bp and 77bp respectively as the demand for EUR credit spilled over into lower rated bonds.
Source: Bloomberg, Invesco as at 31 Jan 2023
Keep an eye on…
Spreads and relative value between traditional high yield and subordinated debt. Following the recent rally, spreads on traditional high yield are trading tighter than long term averages and its lower issuer rating could make it more vulnerable to an economic downturn than subordinated debt.
Fixed Income ETF Flows
With $9.4Bn net new assets, January was the strongest month for net inflows into fixed income ETFs ever1, even surpassing the buying seen in April 2020 following the aggressive central bank response to the pandemic.
Two key themes were seen in the January flows. Firstly, there was very strong demand for EUR-denominated assets, with EUR investment grade credit (+$4.0Bn) the strongest category, followed by EUR government bonds (+$2.0Bn). Second was that investors are increasing risk within their fixed income portfolios with emerging market debt (+$0.9Bn) and high yield (+$0.9Bn) taking third and fourth places. Aggregate bond (+0.9Bn) and investment grade credit ETFs (+$1.4Bn across USD, GBP and global) also saw strong demand.
Outflows were limited with only cash management (-$0.9Bn) and inflation (-$0.7Bn) seeing outflows of more than $0.1Bn.
Source: Bloomberg, Invesco as at 31 Jan 2023
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).

Source: Bloomberg LP, Past performance is not a guarantee of future results.
- If 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 45bps to 4.64% as of the end of January 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 Swap Index Yield
- The current yield on the SIFMA Swap Index is 1.87% as of 01/31/2023, 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 (the highest since 2009) with yields still remaining near 5% across the curve
- 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.
Footnotes
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1
Source: Bloomberg, Invesco based on flows since August 2013
Investment risks
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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.