Yields benefit from flight to safety
US Treasury and German Bund yields increased substantially during the third quarter of this year. Several factors have been contributing to this rise. Economic data remains strong, especially in the US, helped by the AI boom, while energy prices remain elevated. Together, they are keeping inflation uncomfortably high.
This has resulted in both the Federal Reserve (Fed) and the European Central Bank (ECB) hiking rates in September. On top of that, many governments are dealing with high debt loads and budget deficits. This is increasing term premia, the compensation investors demand for holding long-term bonds, driving up long-term bond yields.
Over the past few weeks, however, the rise in bond yields has paused as investors stepped in to lock in these higher yields. For long-term investors that can withstand some volatility as they intend to hold their bonds to maturity, this is indeed not a bad time to buy. Our base case remains that the number of rate hikes from central banks remains limited, which should allow yields to come down next year.
However, in the short term, we are a bit more cautious. We do not yet see an imminent change to the factors that have been driving yields higher. Wednesday’s US inflation report is an example of that. Analysts were not expecting another Fed rate hike at its next meeting on 28 October. However, after the release of this report, they became less certain about that view. Bond yields spiked higher, but interestingly the move was reversed quickly and yields even moved substantially lower.
This cannot be viewed in isolation from developments in equity markets, where AI trades were unwinding. Bond yields thus benefited from a classic flight to safety. Although it is positive to see bonds taking on this role again, it means the rally in yields may not be sustainable should panic related to the AI trade turn out to be short-lived again.
Furthermore, we see several risks for bond markets in the short term. The status quo between the US and Iran does not seem sustainable, and President Donald Trump may well look to take action again after the midterms. In Europe, France is facing a volatile ride going into the presidential elections next year. This could negatively impact the broader Euro bond market, as we have already seen over the past weeks. And of course, several elections are approaching, which may bring a wave of populism and Euroscepticism.
Overall, we maintain our preference for high-quality corporate over sovereign risk. The corporate segment benefits from better diversification and is therefore less exposed to risk from political events. Moreover, many companies have strong balance sheets. We like covered bonds as the safe haven asset in our portfolio, and investment-grade rated corporate credit for their attractive yields. Yields are of course even higher in the high-yield segment, but we remain underweight for now. Valuations remain uncompelling while higher yields for longer are a risk to many of these companies of lower credit quality.