Fixed income: where we stand

Government bond yields in the US and Europe have risen strongly since early August as the market has adjusted to central banks’ increased resolve to tackle high inflation. But market participants expect policy rates to end up higher than our own forecasts for terminal rates. As a result, in keeping with our expectations for a mild recession, we are sticking with our forecast that 10-year US Treasury yields will fall to from 3.2 to 2.6% and their German Bund equivalents from 1.5% to 1.3% by the end of the year, while UK gilt yields should stabilise at 2.8% (around their level at the start of September).

The rise in yields is increasing the appeal of safe-haven government bonds (US Treasuries and core euro bonds) as economic downturn bites and inflationary fears start to abate. But we see peripheral euro debt and UK gilts as much less attractive. We do not expect the European Central Bank’s Transmission Protection Instrument to be activated before the Italian elections in late September, meaning that Italian sovereign bond spreads over Bunds could remain volatile for a while.

Even though they widened again in the second half of August, investment-grade (IG) and high-yield (HY) corporate bond spreads remain below July’s peak levels, despite widespread expectations that the US and European economies could soon fall into recession. We have revised our year-end forecasts for US HY credit spreads up to 600 bps from 450 bps and to 650 bps from 470 bps for euro HY credit.

Given the highly uncertain current backdrop, we continue to prefer ‘safe’ carry in the IG segment. Thanks to the sharp rise in US Treasury yields this year, the yield offered by short-to-medium-term US IG credit looks appealing. But in an environment of volatile sovereign yields and credit spreads we favour a low-duration exposure, and we maintain our underweight in HY credit.