The European Central Bank finally started the ball rolling by easing monetary policy this month. It’s only a matter of time before the other key central banks follow suit and we see the rate-cutting cycle broaden out. However, we think the US Federal Reserve (Fed) will only cut rates up to two times before year-end.

What does the past teach us about the implications for fixed-income assets? We’ve dived into the history books to see what happened to bond returns in that first year following the all-important ‘first cut’.

What does history tell us?

There have been 10 ‘first’ rate cuts in the U.S. since 1980 (see Chart 1). It shows us that total returns for both investment grade (IG) corporate and government bonds after 12 months were positive on every single occasion.  

Source: Bloomberg, Bank of America Merrill Lynch indices, as of June 2024. Note: Treasuries Blended Average = 50% BAML Treasury Index, 50% 7-10yr BAML Treasury Index.

IG outperformed government bonds during five of the 10 cycles. That said, when a rate cut was followed by a significant economic slowdown – such as in 1980 and 2007 –higher-rated government bonds performed much better.

Elsewhere, lower-rated high-yield debt (HY), is more sensitive to the end of economic cycles and performance was mixed – with three negative and two flat years (out of seven).

If we are near the first rate cut in the U.S, then history suggests adding exposure to government bonds (and the longer duration to maturity that comes with them). This is especially true if a recession is around the corner.

Corporate over government?

On the corporate front, credit spreads have also come a long way after a 15-month rally. Spreads indicate the additional yield over comparable government bonds investors demand to take on extra risk.

US IG spreads and HY spreads have tightened to their 20th percentile this century. This poses something of a conundrum for investors – all-in yields are attractive but corporate spreads are now on the expensive side.

But despite these spread levels, there are many reasons why credit could still outperform over the next 12 months.

As things stand, economic forecasts point towards the Eurozone emerging out of recession and achieving gross domestic product (GDP) growth above 1%. Meanwhile, US growth is slowing moderately into the 2%-3% range.

Using history as our guide, this 1%-3% GDP-growth range, with inflation broadly approaching target, is the ‘sweet spot’ for credit markets – and IG outperforms government bonds almost every time.

Spreads may not be cheap, but IG still offers 1% additional yield over government bonds, with expectations for rate cuts to come (see Chart 2).  

What’s more, corporate spreads in Europe are not as narrow, based on their own history, as they are in the U.S. European spreads have room to tighten further (see Chart 2).

Healthy companies

Meanwhile, corporate fundamentals are strong. Leverage – debt levels to operating profit – is far from alarming, and profit margins have, so far, held up relatively well.

While interest coverage ratios – operating profit, as a proxy for cash flow, divided by the annual interest expense – have fallen, they are stabilising at still healthy levels.

Credit ratings are net positive – reflecting more upgrades than downgrades – and the overall ratings composition of the major credit indices for both IG and HY bonds have improved over the last three years.

But it’s not all rosy…

At the start of this year the focus was all on slowing growth and a potential US recession. It then shifted to sticky inflation as a potential catalyst for further rate rises. The latter risk is still a concern, but these issues have diminished in importance.

Geopolitics is now grabbing a lot of attention. International politics has risen as a potential threat to market stability for many investors.

Finally, it is also inevitable that idiosyncratic risk will rise as a consequence of the rapid rise in interest rates. This, however, will also provide opportunities for active managers.

…the HY risk

If we experience the benign macro environment we’ve outlined in the ‘sweet spot for credit markets’ scenario, then HY may well deliver outperformance versus IG for the fourth year in a row.

That said, investors will need to weigh up this possibility against another consideration –the additional yield available in HY has fallen to the lowest level this century versus IG.

Proceed with extreme caution as pricing leaves very little protection for any nasty surprises – whether economic or political.

Final thoughts

It has taken its time but we are approaching that first rate cut in the US. Based on starting yields and lessons from history, it’s likely this will mean strong positive total returns for both investment-grade corporate and government bonds.

Credit spreads are increasingly expensive. But demand for corporate bonds remains robust and the economic environment continues to look conducive to further outperformance.

However, high-yield debt may no longer provide enough adequate compensation for the risks out there – known and unknown.