Corporate bonds: once again Teflon-clad in the face of interest rate volatility

Daniele, what have been the biggest challenges for corporate bond investors so far in 2024?

2024 has not been a boring year for bond investors! Uncertainty about inflation and central banks' self-proclaimed data dependency have led to high interest rate volatility. Elections were held in many countries, polarising citizens. And the most important one, the US presidential election, is still to come. Add to this the tense geopolitical situation and uncertainty about economic developments.

How have global corporate bonds responded?

Corporate bonds have once again demonstrated their Teflon qualities. Although the volatility in interest rates has affected absolute performance, the risk premium - the excess return over government bonds - has steadily declined. Even during the stock market correction in August, there was no sign of panic. The resulting moderate widening of spreads has created some interesting investment opportunities.

What do you think is behind this resilience?

Strong investor demand and high inflows of funds looking for investments have been an important pillar of support for the market. Even the avalanche of new issuance was easily absorbed. Yield-driven investors continue to favour the investment-grade corporate bond market. These favourable conditions are likely to be reinforced in the fourth quarter by positive seasonal factors.

What exactly can we expect?

Corporate bonds are in a sweet spot in terms of the economic environment that markets expect, with low inflation and moderate growth. In addition, investment-grade issuers have very strong balance sheets and can easily withstand an economic slowdown.

Does this apply to all sectors and issuers?

No, we are very cautious on some cyclical sectors in particular. For example, the auto sector faces several challenges. In addition to slowing consumer demand, manufacturers and suppliers are struggling with self-inflicted overcapacity and a politically driven transition to e-mobility. We therefore favour non-cyclical sectors such as healthcare and telecommunications. We also like the energy sector as a cheap hedge against geopolitical upheaval. As the environment is uncertain and risk premiums are relatively low by historical standards, issuer selection remains key.

What do you look for?

We prefer solid companies with transparent business models, and we also like to buy subordinated bonds from them. Subordinated bonds in both the financial (banks and insurance companies) and non-financial (corporate hybrids) sectors offer an interesting extra premium and have been among the best performing segments in fixed income so far this year.

The Fed was the last major central bank to cut rates last September, and further cuts are expected. What does this mean for the bond market in general and for corporate bonds in particular?

The rate cuts that have already been implemented and the expected moves that have been priced into the yield curves have led to a long-awaited normalisation of the yield curves. For the first time in more than two years, the yield on two-year US Treasuries is below that on ten-year Treasuries.

What does this signal?

Steeper curves are good for corporate bonds because they attract yield-seeking funds from lower-yielding short-term assets. Lower short-term interest rates also have an indirect positive effect on corporate bonds, as they reduce the cost of financing for companies and consumers and support the economy. Last but not least, lower short-term US dollar and euro rates also make global corporate bonds more attractive for Swiss investors, as they reduce the spread to local interest rates and thus the cost of currency hedging.

Which sectors benefit most from lower interest rates?

The main beneficiary of lower interest rates is undoubtedly the real estate sector. After a disastrous year in 2022, when the abrupt rise in interest rates sent risk premiums soaring and many real estate companies were unable to access the bond market to refinance their debt, the sector has outperformed by far this year. Nevertheless, we remain cautious, especially on European real estate companies, as leverage is very high and structural problems remain. For financials, the picture is mixed. On the one hand, net interest margins will suffer from lower interest rates, but steeper curves have a positive effect on maturity transformation. Overall, we remain positive on banks and insurers, but we focus on the more solid national champions.

To what extent do you think the US presidential election plays a role in bond selection - and which sectors are favoured if Harris or Trump is elected?

The impact of the US presidential election on the markets is often short-term, difficult to gauge and often overestimated. In general, a victory for the Democratic candidate would tend to be negative for equity markets and the dollar, leading to lower interest rates, while a Trump victory would have the opposite effect, but this would be overshadowed by his notorious unpredictability. Whatever the outcome, the end of uncertainty will be positive. The impact on corporate bonds would at best be indirect and more long-term in nature. We have reviewed our positioning in US healthcare but have not made any further election-related changes.