The bond market has seen further challenges in 2023, but where does it stand now? Stuart Chilvers, Rathbone High Quality Bond fund manager provides an overview.
And just like that, we are through the halfway mark in the year. It feels a natural time to take stock of where we are in bond markets, and what has taken place in the first half of the year.
Economic data has generally followed the trend we saw in 2022: continuing to confound forecasters. Activity data has remained more robust than expected, inflation has generally proved stickier than had been anticipated (particularly here in the UK) and employment has remained remarkably resilient, which in turn has meant wage growth has generally been stronger than expected. While there have been pockets of stress, such as the failure of some US regional banks and the enforced takeover of Credit Suisse by UBS, this hasn’t translated into wider systemic issues.
All this has encouraged a re-evaluation of interest rate expectations. At the start of the year, the implied peak Fed Funds Rate in the US was 5% to be reached in June and two cuts by the end of the year. Markets are now pricing one or two more hikes before year-end from the current level of 5.25%, while the latest ‘dot plot’ produced by the Federal Reserve implies another two rate hikes by the end of the year. In the UK, implied peak rates at the start of the year were 4.75% (to be reached in September), whereas markets are now pricing for base rate to reach 6% in early next year. UK rate expectations responded in kind after the Bank of England re-accelerated the pace of rate hikes in June to half a percentage point after core inflation, wages and employment data all came in stronger than it had forecast in its May Monetary Policy Report.
Unsurprisingly, this has put pressure on gilt (UK government bond) yields. The rise in yields is most significant at the shorter end of the curve (as you would expect), with two-year gilt yields climbing about 1 percentage point in the first half of the year (in early July they were roughly 1.7% higher). That being said, longer-dated bonds came under pressure as well, with the 10-year gilt yielding 50 basis points more over the same period. So far, this all sounds depressingly familiar to 2022, one of the worst years in a generation for bond investors. However, when we look at the first-half performance of the gilt index as a whole, we see it fell only 3.8%. While clearly not great, it’s far better than the big falls of 2022 (performance of this index in the first half of 2022 was -14.8%). This reflects two linked facts. First, while the move in interest rate expectations this year are significant, they are still much smaller than those of 2022. Second, the yields these bonds offered at the start of 2023 were much higher than 2022 – that means the ‘carry’ (ongoing interest received) investors earn for holding these bonds is much higher this year, which helps compensate investors as yields move higher.
If we look at investment-grade corporate bonds, the picture improves: the ICE Bank of America Sterling Corporate Index lost just 1.0% over the first half of 2023. In the first six months of 2022 it lost 14.8%. This better performance is driven by a few different factors:
• Corporate bond indices tend to be shorter duration than government bond indices, so are less sensitive to rising yields
• The additional carry earned due to the higher yield of the index (due to the additional credit spread received for the credit risk being taken)
• These credit spreads have actually tightened slightly over the first half of 2023, as company earnings were generally resilient and investors re-evaluated the risk of recession, given better-than-expected economic data.
So, while 2023 has been another challenging year for bond investors, performance hasn’t been anywhere near as negative as 2022, with carry returning as a meaningful contributor to returns. With current yields on offer, this will continue to be the case and help to compensate investors for the risk that inflation remains stickier than central banks expect.
Any views and opinions are those of the investment manager, and coverage of any assets held must be taken in context of the constitution of the funds and in no way reflect an investment recommendation. Past performance should not be seen as an indication of future performance. The value of investments may go down as well as up and you may not get back your original investment.
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