Interest rate turnaround ahead: promising corporate bonds

Last year ended on a high note for fixed-income investors. The spectacular price rally in November and December was all the more impressive after periods both in 2022 and, at times, 2023 were characterised by painful losses and high volatility. Corporate bonds in particular benefited from the increased appetite for risk. This is unlikely to be a one-off event as the outlook for the asset class for the rest of the year is better than it has been for a long time – this applies to all three sub-categories: Investment Grade, High Yield and Emerging Market corporate bonds.

Investment grade bonds in pole position
Investment grade bonds are offering the most appeal in terms of risk and return potential in view of the ongoing restrictive monetary policy, the weakened economic cycle, declining inflation and fair valuations. Historically, the peak in key interest rates has always been the ideal time to enter the market. There is a broad consensus that this pivot has been reached. In the subsequent cycles of interest rate cuts – the market is currently pricing in Fed rate cuts of 130 basis points for 2024 – corporate bonds have significantly outperformed the equity markets. In fact, we are currently seeing an extremely rare phenomenon: US investment grade bonds are yielding more than equities for the first time in at least 20 years (the earnings yield of equities is the inverse of the price/earnings ratio). The high interest rate level also offers an effective yield buffer in view of possible widening credit spreads. Even in a realistic negative scenario with a 40 basis point increase on an index basis, the achievable annual return on global IG bonds would still be around 3% (hedged in US dollars, compared to around 5.6% currently and around 4.1% on 10-year US Treasuries). Until a total return loss occurs, even a widening of 80 basis points would be manageable (so-called "break-even yield").

High yield: Attractive compensation for higher risk
Investors who are looking for even higher yields and for whom the economic glass is half full should take a closer look at the high-yield segment. The achievable yields there are around 7.5% in USD high-yield and 6.1% in euro-denominated bonds (in local currency without hedging). The priced-in default rates are of course higher, but at the same time the issuers' fundamentals are very solid and should be able to cope with a moderate economic downturn. A low debt ratio and robust debt sustainability in view of good cash flows speak support this view. This also means that the default rate remains low, with at most a slight increase towards the long-term average of 4%. However, investors expecting a severe recession – a scenario that few market observers are currently predicting – should keep their distance from the high-yield segment. Apart from this worst-case scenario, however, the high total returns should at least withstand a certain widening of risk premiums.

Emerging markets as a phoenix from the ashes
With emerging markets (EM) bonds, it is worth looking beyond the pure yield figures. Because EMs have – superficially viewed – had to cope with significantly more bad news than positive signals in recent years (Ukraine, China, Middle East), their attractiveness may not be obvious at first glance. However, this view does not do justice to the extremely heterogeneous nature of this asset class, as the trouble spots are localised, rather than contagious, and the universe offers a broad spectrum of opportunities. The macro perspective already speaks for itself: on average, EMs have been able to maintain their lead over the developed nations in terms of economic growth and will probably even increase it again in 2024. Added to this are the positive fundamentals of the companies, which have very low debt ratios across all rating segments – even relative to their competitors in the industrialised nations. Investors are also benefiting from a favourable technical market environment, in which more outstanding bonds are being repaid than are newly issued. This negative net financing volume creates excess demand, which would support bond prices in the event of spreads widening, and thus limit the move. The technical environment is also influenced by the fact that many investors actually have little to no EM exposure – with a downward trend. However, we actually see this as positive: if the negative fund flows of recent years were to reverse, which is only a matter of time, the asset class would benefit disproportionately.

In the current market scenario, investment-grade bonds offer solid returns compared to equities, while risk-tolerant investors will find attractive opportunities in the high-yield segment and in emerging markets. A differentiated portfolio strategy remains crucial in order to be able to react flexibly to market developments.