Bond yields initially moved higher in the second quarter in response to hotter-than-expected inflation readings early in the year but then drifted back down as both growth and inflation moderated. Lower-quality credit performed best despite developed-market spreads inching modestly wider.
In the US, inflation has decelerated to levels that, if growth were to weaken faster than expected, would now allow the US Federal Reserve (Fed) to cut rates, which has improved the total return prospects for bonds going forward. We don’t foresee significant Fed easing in 2024, but investors shouldn’t miss the opportunity to lock in attractive yields and potential diversification benefits from the price appreciation that would result from any surprise cuts in interest rates.
All-in yields remain attractive across fixed income sectors, but tight spread levels keep us cautious on below-investment-grade risk.
In monitoring fixed income markets for opportunities, we are constantly asking ourselves whether the potential upside of a decision adequately compensates us for the risk of the downside. Getting to the right answer, however, requires an assessment of potential market outcomes well beyond a base-case view. For us, constructing optimal portfolios starts with a detailed analysis across a range of economic scenarios. A probability-weighted approach provides a better foundation to identify opportunities and manage risks.
In recent months, the worst-case scenario for bonds—a re-acceleration in inflation, and even higher interest rates—has faded. Growth indicators have been somewhat mixed, but there are increasing signs of weakness and recent inflation readings have been lower than expected.
We believe we are approaching a turning point in the economic cycle, which historically has been a good environment for higher-quality bonds. In our view, the risk of a near-term downturn is still low, but we are mindful that a prolonged period of restrictive policy rates poses a risk to the most vulnerable fixed income segments, where most of the good news has already been priced in.
Investors should take note that real interest rates—the expected return from yields after expected inflation is subtracted—remain near recent historical highs. The entire real yield curve is higher today than it was a year ago, and two to three percentage points higher than the day before the Fed started raising rates.
Higher starting yields imply higher returns and better downside protection. Even if rates generally moved up, higher yields today relative to the beginning of 2022 can help offset any losses from price changes.
US Treasury par real rate curve
Notes: Graph shows the par real rate yield curve for US Treasuries on 16 March 2022, 30 June 2023 and 30 June 2024. 16 March 2022 is the day before the Fed began raising interest rates in the latest hiking cycle. Par value is the face value of a bond and is typically $100; a par yield therefore is calculated using the par value.
Source: US Treasury.
It’s been almost a year since the Fed last raised its policy rate. Despite substantially higher borrowing costs, the US economy continues to show strength. After a brief scare in the first quarter of 2024, inflation appears to be back on a better path. While recent readings are encouraging, our forecasts show core inflation, which excludes volatile energy and food prices, trending sideways around the high 2% range into 2025, which underlines the challenge of slowing all the way back down to target.
Stable growth and sticky inflation alongside a firm, but gradually normalising, labour market are consistent with the market narrative that policy rates are likely to remain higher for longer. Our base-case view continues to be that the Fed will remain on hold with its policy for most, if not all, of this year. Monetary policy is highly data-dependent, and the data has shown that it is too soon for the Fed to start cutting yet.
If the economy were to weaken faster than expected, the more modest inflation trend we’ve seen recently would allow the Fed to cut rates if needed.
Growth outside the US has improved and progress in taming inflation has allowed some central banks to begin to ease policy. However, the Fed’s approach is likely to impact, to varying degrees, what rate cutting cycles will look like globally.
A higher-for-longer scenario for rates can be supportive for markets if certain conditions hold. If inflation continues to slow gradually, markets will have less uncertainty around the next moves by major central banks. If growth is good enough, cracks are less likely to appear in credit markets. In that scenario, markets can hold within predictable ranges while higher yields generate more attractive returns for investors.
The risk that concerns us most is around the potential for ‘higher-for-longer’ to become ‘higher-until-something-breaks’. For us, valuations and credit quality are still the key factors driving our portfolio strategy. In our view, government bond markets are more appropriately priced for these uncertainties whereas the lower-quality segments of credit are not.
Fixed income sector returns and yields
Sources: Bloomberg indices and the J.P. Morgan EMBI Global Diversified Index. Q2 2024 return data from 31 March 2024 to 30 June 2024; 2023 return data from 31 December 2022 to 31 December 2023.
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. Performance is provided on a total return basis, in the base currency of the index, or for global indices, USD hedged.
In the US, 10-year Treasuries have traded with yields in a range of 4.25% to 4.75% in recent months. We think recent data have likely shifted the yield range lower over the near term, to between 4.00%-4.50%, but we are conscious that rising fiscal concerns could present upside risks to yields. At this point in the cycle, we are biased towards adding duration and will look for attractive risk/reward opportunities to do so if rates test the top end of our expected range.
In Europe, the European Central Bank (ECB) lowered its deposit facility rate to 3.75% at its 6 June meeting, after holding it at a cycle high of 4% for nine months. We continue to expect euro area periphery countries to outperform Germany economically. As a result, we anticipate that the yield spreads of government bonds issued by periphery countries like Greece and Spain will narrow relative to German government bonds, along with the periphery countries’ improving relative economic fundamentals. Post-Covid spending across the region has shifted towards service-led sectors, leaving economies with a greater industrial footprint, like Germany, not reaping the benefits to the same extent as peripheral countries. Additionally, Germany’s disciplined approach to fiscal policy has helped it keep its debt levels sustainable but has limited the fiscal stimulus available to support stronger economic activity and growth.
The UK and France both called snap elections during the second quarter, and voters headed to the polls in early July. In the UK, the Labour party won a landslide victory—as markets had expected—increasing the party’s share of parliamentary seats by 209 to 411 and defeating the governing Conservative party. The extent of Labour’s majority in parliament should facilitate the implementation of their plans in the coming years.
In France, strong support for the country’s right-wing National Rally party surprised markets ahead of the first round of elections, causing spreads between French and German bonds to widen amid concerns around potential higher fiscal spending in France. However, a series of withdrawals in the second round of elections by left- and centre-leaning candidates left voters with fewer choices on second-round polling day; this paved the way for the left-wing New Popular Front party to win the highest number of seats (188 out of 577) in the French parliament, but failed to secure them a majority position. While spreads on French bonds could narrow in the near term, a hung parliament may present challenges, especially given the pressures on the new government to bolster France’s weakened economy by raising spending while also tackling rising fiscal deficit concerns.
Elsewhere, we continue to underweight Japan as interest rates there remain low and wages continue to rise – which could support inflation. We expect the Bank of Japan (BoJ) to reduce their purchases of Japanese government bonds (JGBs) and increase interest rates in the coming months.
On curve positioning, we continue to look for ways to benefit from the steepening trend in the yield curve that we believe will continue to develop. Timing is challenging, but thematically there are several factors that should contribute to a more typical upward-sloping curve shape. In the near-term, however, we remain more opportunistic.
Outside the US, we see opportunities across global government bond markets. We are overweight to Greece and Spain relative to Germany and remain underweight to Japan, for example.
Quarterly changes in credit spreads
Notes: Chart shows the quarterly changes in spreads for credit market sectors for the 3-month period from 31 March 2024 to 30 June 2024. EM IG and EM HY refer to emerging market investment-grade and high-yield, respectively.
Source: Bloomberg and J.P. Morgan indices.
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Our outlook for credit markets is positive over the near term but downside risks are growing more prevalent, especially in lower-quality segments that have benefitted from the soft-landing scenario that has helped drive spreads lower over the last eight months.
Broadly, we still see strength in underlying credit fundamentals and the supply/demand dynamic is looking more favourable now that we’ve made it through the front-loaded wave of new issuance at the start of the year.
Investment-grade credit should perform well across a range of economic scenarios. Higher-rated bonds are better positioned if borrowing costs remain higher for longer, but they would likely also be more resilient in an economic downturn scenario. If the economy slows quickly, credit spreads would likely widen, but total returns should be supported by a corresponding cut in interest rates.
High-yield credit would be more vulnerable in both economic scenarios, and the asset class currently offers too narrow a spread premium to justify a large allocation.
With spread valuations stretched, our strategy is biased towards higher-quality credit and a focus on maximising yield while reducing our portfolios’ sensitivity to broad market risk. We like opportunities at the front-end of the curve within financials, European corporates and investment-grade emerging markets, given the spread uplift.
This strategy allows our portfolios to benefit if credit continues to perform well. But if the broader economy weakens, our more defensive approach should hold up better and provide room to add back credit at more attractive prices.
View:
Strategy:
View:
Strategy:
View:
Strategy:
View:
Strategy:
View:
Strategy:
Vanguard’s Fixed Income Group manages $1.7 trillion globally in active and index funds with a global team of more than 180 investment professionals.
Vanguard’s active fixed income team manages over $449 billion across various actively managed fixed income strategies. For more than 35 years, Vanguard has managed active fixed income funds with an experienced team of credit research analysts, traders and portfolio managers.
Our investment teams are supported by our 50-plus member economic research team that informs our economic outlook and our 85-plus member risk management team that is integrated into our investment process.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Past performance is not a reliable indicator of future results.
Some funds invest in emerging markets which can be more volatile than more established markets. As a result the value of your investment may rise or fall.
Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.
Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.
Reference in this document to specific securities should not be construed as a recommendation to buy or sell these securities, but is included for the purposes of illustration only.
Important information
For professional investors only (as defined under the MiFID II Directive) investing for their own account (including management companies (fund of funds) and professional clients investing on behalf of their discretionary clients). In Switzerland for professional investors only. Not to be distributed to the public.
The information contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information in this document does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this document when making any investment decisions.
The information contained in this document is for educational purposes only and is not a recommendation or solicitation to buy or sell investments.
Issued in EEA by Vanguard Group (Ireland) Limited which is regulated in Ireland by the Central Bank of Ireland.
Issued in Switzerland by Vanguard Investments Switzerland GmbH.
Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.
© 2024 Vanguard Group (Ireland) Limited. All rights reserved.
© 2024 Vanguard Investments Switzerland GmbH. All rights reserved.
© 2024 Vanguard Asset Management, Limited. All rights reserved.