Midterm relief for bond markets
Bond markets gained some breathing room this week. Democrats won control of both the House of Representatives and the Senate in the US midterm elections. The result reduces concerns about further government spending under the Trump administration, as the Democratic-controlled Congress is likely to block much of President Trump’s remaining legislative agenda. The 10-year Treasury yield fell to around 4.9%, after reaching close to 5.3% in October.
Despite the decline in bond yields this week, markets continue to expect another interest rate increase from the Federal Reserve in December. Friday’s payrolls report is likely to indicate whether those expectations remain intact. Government borrowing also remains very high, so the supply of government debt is likely to stay an important driver of long-term yields, even if the pressure eases somewhat.
In Europe, headline inflation rose to 4.0% in October, while core inflation remained at 2.5%. Headline inflation measures overall consumer price growth, while core inflation excludes volatile components such as food and energy and can provide a clearer picture of underlying price pressures.
Inflation therefore remains uncomfortable for the European Central Bank, and markets continue to expect another interest rate increase in December. Bund yields nevertheless followed US Treasury yields lower this week, with the 10-year Bund yield falling to around 3.3%.
European governments also continue to issue substantial amounts of debt, particularly bonds with longer maturities.
Credit spreads have widened in both the US and Europe, although investment-grade (IG) bonds have held up better than riskier high-yield bonds. EUR and USD IG spreads are now around 100 basis points and 90 basis points, respectively. That is wider than earlier this year, but spreads are still not particularly attractive.
High-yield bonds have become more interesting following the recent widening in spreads. USD high-yield spreads are around 335 basis points, while euro high-yield spreads have risen to around 360 basis points. Investors are therefore being paid more for accepting the greater risk associated with these bonds.
However, we do not yet believe this additional return is sufficient to justify moving into lower-quality debt, especially since refinancing costs are still high. The widening is nevertheless something to watch. If it continues, high yield could become more attractive.
We remain selective, favouring high-quality corporate bonds over sovereign debt. We also prefer bonds with medium-term maturities over shorter- and longer-dated bonds. We remain cautious on high-yield bonds and avoid chasing yield where valuations do not adequately compensate for the underlying risks. With governments and companies continuing to issue substantial amounts of debt and thus competing for investor capital, maintaining investment discipline remains essential.