Interest rate cuts yes, but when and how much?

In recent months, the overly optimistic interest rate cut expectations prevailing at the turn of the year have been scaled back significantly. The result: rising bond yields in the USA and the Eurozone. At the same time, however, spreads on corporate bonds have declined considerably. This is an unusual combination. On one hand, it has led to a situation in which the price losses caused by the general rise in yields have been largely offset by interest income and falling risk premiums. On the other hand, this trend means that corporate bonds are still attractively priced for investors from a fundamental valuation perspective.

There are currently still many factors that suggest that capital market yields across all maturity segments will be lower than they are right now over the coming 12 to 18 months. This would mean price increases for bonds and imply highly positive returns for corporate bonds with good ratings during this period. Naturally, however, there is no guarantee that this will materialise. Other, less advantageous scenarios are also possible, for example in the event of less favourable economic or inflation developments or more severe geopolitical escalations.

Investment grade corporate bonds still promising

The investment grade segment (meaning bonds with high ratings) currently appears to have a somewhat better risk/earnings ratio than the high yield segment, where issuers with lower ratings are traded. With Raiffeisen-ESG-Euro-Corporates, Raiffeisen KAG is offering an investment fund that is oriented specifically towards investment grade corporate bonds while investing on the basis of sustainability criteria (see also ESG: three letters, one sustainability approach). The average bond yield within the fund portfolio is currently around 4% p.a. This metric only serves as a rough orientation, however. The actual return for the investor is influenced by various other factors. This means that it can be lower or higher.

The market is currently pricing in an “ideal world”

Over the past 12 months, corporate bonds have profited considerably from narrowing credit spreads versus German Bunds. This yield premium currently averages 105 basis points for euro investment grade corporate bonds versus German government bonds and around 350 basis points for high yield bonds (1 basis point = 0.01%). Historically speaking, this is far below average. This means that on market average, around 1.05% more or around 3.5% more yield is being paid per year than for German government bonds.

These credit spreads are pricing in a kind of ideal scenario, i.e. positive but not excessively rapid economic growth, a falling inflation trend, a low and decreasing number of defaults, and good refinancing conditions – with only moderate risks to the continuation of these conditions. Looking back at historical development in recent decades, corporate bonds have virtually never outperformed euro government bonds to the extent they have in the past 12 to 18 months. One key reason for this is likely the extremely high capital inflows into these bonds in recent months. Essentially all investors have increased their purchases significantly in the last few months. Investors apparently see the absolute yields offered by corporate bonds as attractive even though spreads versus government bonds have fallen well below the long-term average, so that the yield advantage compared to government bonds is no longer all that high.

Risks: Geopolitics, negative economic and inflation surprises

But it is anything but certain that this good situation will persist. Economic growth and inflation may take a different course in the coming quarters than what is currently expected according to the market consensus, even if the current data provide little indication of this. The geopolitical situation is also more fraught with tension than it has been in many decades, and this offers potential for sudden, significant price movements.

Credit spreads seem ripe for narrowing

The present, rather low risk premiums are primarily the result of current good liquidity and strong demand from investors. They are also reflecting the expectations for extensive interest rate cuts in the near future, with corresponding positive effects on corporate refinancing costs. However, many companies seem to have become more sceptical on this front now, as the average term of the bonds being issued is on the rise. This means that many companies are locking in the current financing conditions for a longer period of time. In addition, there is a great deal of differentiation when it comes to fundamentals within the corporate sector. While the highest-rated segments exhibit quite solid (i.e. relatively low) debt metrics, the figures for lower-rated issuers within the investment grade sector have increased significantly of late. Thus, there are certain warning signs in this segment, which also underlines the fact that good issuer selection remains crucial.

More on the topic of bonds and on the capital markets.