Fixed income markets are facing pressure as inflation expectations revive. Where are the vulnerabilities?
- Corporate bond spreads are low, and inflationary pressures are weighing on longer-dated bonds
- Tariffs alone could add up to 1.3 percentage points to US inflation in 2025
- Yield curves are currently flat, but many fixed income managers are expecting them to steepen
Corporate bond spreads are now at their lowest level since the 1990s. Investors have pushed spreads lower as the threat of recession has faded and a ‘soft’ or no landing scenario has become increasingly likely. There are also risks to government bond yields should inflation rebound once Trump is in office. How comfortable should investors be with fixed income today?
For some time, the assumption has been that interest rates and inflation will fall and this will be good for bond markets overall, particularly at the higher quality end. The Trump victory and the UK budget make this increasingly unlikely.
Trump’s policies on immigration, tariffs and tax cuts are inflationary. It may be that he abandons tax cuts, having seen the way the US electorate responds to periods of inflation, but that still leaves the impact of the other two. Research from Nataxis suggests that tariffs alone could add up to 1.3 percentage points to US inflation in 2025.
It is possible that this is tempered by Trump’s plans to ‘drill, baby, drill’, and lower energy costs for Americans. However, this will take time to come on stream and is unlikely to mitigate the impact in the short-term.
Yield curves are currently flat, but many fixed income managers are expecting them to steepen. This is a combination of short-dated bond yields falling in response to cuts in interest rates, and longer-dated bonds rising as markets anticipate future inflation and rate rises. Fixed income managers are huddled in shorter-dated bonds.
Then there is the problem of credit spreads. Investors are getting increasingly little compensation for the additional risk they are taking on corporate bonds. One fund manager pointed out that GlaxoSmithKline bonds trade at a spread of just 0.5% over government bonds. Certainly, default risks look low, but are they really the lowest in three decades?
Active managers can navigate these complexities. There are still areas, such as the ABS market, some financial bonds, where there appears to be value. However, this is not an option open to passive investors in bonds who are forced into the largest and most liquid issuers that form the most significant weightings in the benchmark.
The received wisdom on fixed income is that the ‘all-in’ yield is still attractive. Investors can collect the income, and hold the bonds to maturity without taking significant risks. This is true, but the fixed income market looks complacent about some of the risks, and may be heading for some uncomfortable volatility.
