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. However, we believe 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 US since 1980 (Chart 1). It shows us that total returns for investment grade (IG) corporate and government bonds after 12 months were positive on every occasion.
Chart 1. Bond total return a year after first rate cut
Source: Bloomberg, Bank of America Merrill Lynch indicies, 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. Higher-rated government bonds performed much better when a rate cut was followed by a significant economic slowdown – such as in 1980 and 2007. Elsewhere, lower-rated high yield (HY) debt 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 nearing the first rate cut in the US, history suggests adding exposure to government bonds (and their longer duration to maturity). 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 and HY spreads have tightened to their 20th percentile this century. This poses a conundrum for investors – all-in yields are attractive, but corporate spreads are now expensive. Despite these spread levels, there are many reasons why credit could still outperform over the next 12 months.
Economic forecasts point to the Eurozone emerging from 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 a 1% additional yield over government bonds, with expectations for rate cuts to come. Moreover, corporate spreads in Europe are not as narrow, based on their history, which means they have room to tighten further (Chart 2).
Chart 2. US vs European IG credit spreads*
Healthy companies
Meanwhile, corporate fundamentals are strong. Leverage – debt levels to operating profit – is far from alarming, and profit margins have held up relatively well, so far. While interest coverage ratios – operating profit, as a proxy for cash flow, divided by the annual interest expense – have fallen, they are stabilizing at healthy levels.
Credit ratings are net positive – reflecting more upgrades than downgrades – and the overall rating 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 on slowing growth and a potential recession. Then, it shifted to sticky inflation as a possible 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, the rapid rise in interest rates will undoubtedly raise idiosyncratic risk. However, we believe this will also provide opportunities for active managers.
The high yield risk
Suppose we experience the benign macro environment outlined in the sweet spot for the credit markets scenario. In that case, HY may deliver outperformance better than IG for the fourth year. 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.
We suggest proceeding with extreme caution as pricing leaves very little protection for any nasty surprises – whether economic or political.
Final thoughts
It has taken time, but we believe we are approaching that first rate cut. Based on starting yields and lessons from history, this will likely mean strong positive total returns for both investment-grade corporate and government bonds.
Credit spreads are increasingly expensive. However, the demand for corporate bonds remains robust, and the economic environment looks conducive to further outperformance. However, HY debt may no longer provide adequate compensation for the risks – both known and unknown.
Important information
Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
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