Monthly fixed income update - September 2023

Asset Class Returns
Fixed income markets generally performed poorly in September as economic data indicated a more buoyant picture for the global economy than had been anticipated, while central bank commentary was broadly hawkish on rates. This combination caused yields to rise across global bond markets with the benchmark 10-year US Treasury yield rising by 46bp over the month to end September at a new cycle high of 4.57%. Investment grade credit spreads were little changed over the month, with rising government bond yields the driver behind the negative returns during September. Lower rated Euro-denominated debt was the main exception over the month as spreads tightened which, combined with the higher level of yield offered, led to mildly positive returns over the month.

Source: Bloomberg, Invesco as at 29 Sep 2023
Government and Inflation-Linked Bonds
While economic data was relatively robust during September and central banks indicated that further tightening might be needed to ensure inflation continues to fall back to target, interest rate expectations were little changed over the month. Instead, negative returns for government bonds were driven by a continuation of yield curves steepening which has been a theme for the whole of Q3.
US Rates
The US employment report early in the month provided a mixed picture as the unemployment rate rose to 3.8% but the pace of annual earnings increases remained healthy at 4.3%; survey data for both the manufacturing and services sectors beat expectations. But it was the inflation data mid-month that caused some concerns as the core measure was higher than expected, rising to 3.7%. Although the Federal Reserve held rates at 5.5% later in the month, the accompanying Summary of Economic Projections showed they expect to keep rates higher for longer and now only expect to ease rates by 50bps next year rather than by the 100bps they forecast in June. While US Treasury yields had been drifting higher over the month, this more hawkish tone was the catalyst for the US yield curve to bear steepen, and yields to rise more aggressively into month end. Having risen by 46bp over the month, the 10-year yield ended September at 4.57%, the highest level since the fourth quarter of 2007.

Source: Bloomberg, Invesco as at 29 Sep 2023
Eurozone Rates
While European economic data showed a more mixed picture compared to the US, eurozone rates markets followed a similar pattern to US Treasuries over the month. The ECB hiked rates by 25bp to 4.5% in the middle of the month but there appears to be an increasing divergence of views on the Governing Council as to whether rates have peaked, due to the time it will take for previous hikes to fully impact the economy, or if further tightening will be needed to bring inflation back to target. Like the US yield curve, European government yield curves steepened over the month, driving the negative performance. A possible additional concern for monetary policy makers could be the widening of spreads between core and peripheral government debt. At 1.94% at the end of September, the spread between 10-year German and 10-year Italian government bonds is at the widest levels since March, with the outlook for the Italian budget deficit being the main concern, but the spread on Spanish debt also widened over the month.

Source: Bloomberg, Invesco as at 29 Sep 2023
UK Rates
The UK gilt market was the outlier of the major government bond markets with respect to directionality in September. Although 10-year Gilt yields ended the month 8bp higher, this was far less than the 46bp, 37bp and 66bp rise in yields seen in 10-year US, German and Italian Government bonds respectively. The primary reason for this was the lower-than-expected inflation data, reducing pressure on the Bank of England to hike rates further. Overall, this led to UK interest rate expectations declining over the month but, like other markets, the UK yield curve steepened, helped by the Bank of England holding rates at 5.25%. However, rather than a bear steepening, the curve steepening pivoted around the 7-year point.

Source: Bloomberg, Invesco as at 29 Sep 2023
...inflation data which will be the most important factor for central bank policy.
Investment Grade Credit
Investment grade credit spreads were stable over the month which meant that the negative performance for credit markets was primarily driven by the moves in government bond yields. Overall, it appears that the reasonably buoyant economic data, which should be positive for credit spreads, is being balanced by concerns over the need for further policy tightening to slow the economy, which would be negative for spreads. Having seen strong inflows earlier in the year, investment grade credit ETFs saw some sales in September as investors favoured the “safe haven” assets classes of government bonds and cash.

Source: Bloomberg, Invesco as at 29 Sep 2023
...ETF flows
High Yield and Subordinated Credit
Like investment grade, lower rated credit spreads lacked direction in September. Euro-denominated high yield (-10bp) and corporate hybrid bond (-10bp) spreads were slightly tighter over the month. USD-denominated AT1 (+6bp) spreads were slightly wider as the market remained relatively quiet, although anticipated new issuance could spur interest in the asset class in the fourth quarter. US high yield was the worst performer in terms of spreads which widened by 28bp over the month.

Source: Bloomberg, Invesco as at 29 Sep 2023
...the AT1 market as performance of anticipated new issues could indicate risk appetite
Fixed Income ETF Flows
Net inflows into fixed income ETFs slowed further in September to $1.9bn, the slowest pace since February as investors became more cautious about the outlook for yields. However, with $50.9bn NNA so far this year, fixed income ETFs represent 46% of net inflows, well above their 24% market share by assets under management. Fixed income ETF flows continued to indicate a broadly risk-off sentiment from investors with government bonds and cash management ETFs seeing the strongest inflows, while high yield and emerging market debt experienced outflows. EUR government ETFs ($2.0bn) led inflows in September followed by cash management ($0.8bn) and US Treasuries ($0.5bn). A single large inflow pushed Green Bond ETFs ($0.2bn) into fourth spot while a new category of fixed maturity ETFs ($0.2bn) also saw strong inflows. EM Government Bond ETFs (-$1.1bn) led the outflows, with additional outflows in EM space from China Bond ETFs (-$0.2bn). High yield (-$0.6bn) also suffered in the risk-off sentiment.
The risk off sentiment appears prudent given the outlook. While bonds performed poorly in September, yields have risen to even more attractive levels and, although recent economic data has been relatively buoyant, the longer-term outlook is that growth does appear to be slowing and inflation is falling back towards target. That means there will be less pressure on central banks to tighten policy further, in the months ahead. Although bonds and equities have been more positively correlated recently, once rates do peak, the previously seen low to negative correlation between government bonds and equities is likely to return which would make high quality bonds a useful hedge against equity market volatility once more.

Source: Bloomberg, Invesco, as at 29 Sep 2023
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.