Fixed income: repositioning for rate cuts

With the Federal Reserve’s (Fed’s) decisive start to cutting rates, central banks in every major developed economy bar Japan are in easing mode. This Q4 2024 edition of Alphorum focuses on the implications for fixed income in this next phase of the cycle, and considers the portfolio adjustments and tactical trades that we favour over the next 12 months and beyond.

Portfolio positioning: ease-y does it

The Fed’s announcement followed a concerted campaign by the bank to change the narrative towards a dovish view – a strategy that should reduce the tail risk of a hard landing. But will the much hoped for soft landing materialise, and how should fixed-income investors position themselves as the rate-cutting cycle progresses?

We researched changes in the Fed policy rate during past cutting cycles and found that easing has led to the Fed cutting rates by approximately 350 basis points on average over the first 12 months (see Figure 1).

FIG 1. Changes in the US effective fed funds rate (EFFR) around current and past cutting cycles, by outcome¹

Other key metrics – from activity indicators to labour market figures and the Fed’s Sahm Rule recession indicator – are also broadly tracking paths seen in soft or even no-landing scenarios in the past. However, while markets are now pricing in a relatively smooth and rapid normalisation of rates, questions remain regarding the ‘quality’ of the slowdown in the US economy, while some market volatility may surface in the wake of the US elections in November. With this in mind, there may well be pauses and adjustments within the general downward shift in rates – a situation that can offer tactical opportunities in fixed-income markets.

Overall, we prefer a constructive but defensive stance, with a focus on investment-grade credit to offer an optimal combination of duration risk and credit risk, and inflation-linked sovereign bonds to provide a useful tactical hedge.

Government bonds: constructive but defensive

As falling policy rates erode the appeal of money markets, should investors put their cash to work in sovereign bonds?

In the first half of the year, elevated carry for sovereign debt was still outweighed by yields edging higher. However, as falling policy rates make cash unattractive, sovereign debt is growing in appeal. Already in the third quarter, the sharp move lower in yields led by the front end of the US bond curve lifted the year-to-date performance of the Bloomberg Global Treasury Index (EUR Hedged) out of the red to the tune of 2.5%. Fundamental factors – including the Fed’s decisiveness and the likelihood of ongoing elevated net supply of US Treasuries – support the case for steep yield curves to persist.

Looking ahead, major developed-market central banks should have room to deliver a series of rate cuts over the coming quarters, although monetary policy remains highly data dependent and region specific. Tight financial conditions from a monetary policy perspective but easy conditions regarding equity pricing and credit spreads are also something of an anomaly. However, with real yields for 10-year Treasury Inflation-Protected Securities trading above 1.5%, we continue to see merit in locking in current developed-market bond yields with longer durations.

Corporate credit: time to get real

As interest rates rose throughout the tightening cycle, real-estate bond prices fell, driven by investors concerned about the increasing cost to firms of interest cover and weakening fundamentals. But as rates begin to fall, could it be time to get real again?

Regular readers of Alphorum will know that we’ve been highlighting the relative cheapness of real-estate bonds for some time. That’s because despite the past 18 months or so of weakening financial metrics, widening spreads, liquidity concerns and ratings downgrades in the sector, high-quality assets and reliable income streams mean that most large property firms are both operationally sound and highly resilient. 

As real-estate spreads widened from the end of 2022 through 2023, our confidence in the sector and active research into individual names meant we were able to take advantage of this relative cheapness. This has paid off handsomely in 2024, with many bonds up over 20 points year to date².

FIG 2. Spread comparisons: real estate vs overall levels for IG, HY and HY ex-CCC, January 2018 to August 2024³

Rating agency concerns about interest cover could still lead to some further negative perceptions of the sector, but in our view, this is likely to be limited to a notch or two. That could move some issuers from investment grade to high yield, providing an opportunity to take advantage of any price overreaction.

Systematic research: cuts, credit, correlations and curves

The adage ‘history doesn’t repeat, but it does rhyme’ is often referenced at the point of perceived regime shifts in financial markets. So, can analysis of historical fixed-income market data tell us anything useful about what trades might perform well this time around?

To find out, we analysed data recreating 13 cutting cycles across 60 years of fixed-income market performance. We found that while periods of falling rates tend to favour duration over credit, the range of outcomes suggests a macro dependency on credit performance that needs to be explained.

A more systematic approach to exploiting the situation would involve negative rate-credit correlation, which has been persistent throughout past cycles (see Figure 2). In fixed-income markets, this correlation favours the higher end of high yield, which offers the best balance of both credit and duration exposure, in our view.

FIG 3. Rate-credit correlations during hiking and cutting regimes by central banks, 1953-2020⁴

Another much touted source of potential gains as rates begin to fall are rate-curve ‘steepener trades’. Our research found that within the period studied, US one-year-10-year (1y10y) curves have steepened both six months and 12 months into all instances of cutting cycles. However, with curve steepening already priced into markets, such trades are likely best deployed very tactically, given high carry and rolldown costs.

Sustainability: investors and the ‘finance COP’

Despite USD 1.8 trillion of investment into clean energy in 2023, financing aimed at driving the climate transition falls well short of the estimated USD 4.5 trillion needed annually by 2030. With COP29 being billed as the “finance COP”, can ways be found to deliver the huge sums needed, and what part will private sector finance have to play?

In the United Nations’ global stocktake report compiled ahead of last year’s conference, countries broadly agreed that action so far has been insufficient, with little evidence of aggregate reductions in emissions. To bring investment up to the level required to have the desired impact, sources of funding will need to be scaled up across public, private, development and concessional finance channels. At the same time, to align capital to the transition, policymakers need to deliver strong public policy, sectoral transition plans, biodiversity strategies, climate disclosures and support for emerging markets and developing economies.

Finally, another key theme at COP29 will be adaptation, which has been largely overshadowed by mitigation. COP28 made progress by launching the ‘loss and damage’ fund to compensate developing countries to cope with floods, droughts and other adverse impacts of climate change. As evidence of the impact of climate change grows, adaptation efforts will again be in the spotlight this year as stakeholders increasingly recognise the need to build resilience.

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