From cash to credit: Unlocking yield in a shifting bond market

Explore insights on positioning across the credit spectrum, managing risks, and seizing opportunities in a changing bond market.

After years of very low interest rates in the wake of the Global Financial Crisis (GFC), central banks’ tightening has pushed bond yields to attractive levels once again. 

Source: Board of Governors of the Federal Reserve System (US)
Past performance is not a guide to future performance.

Today, as the tightening cycle begins to unwind, many investors are eyeing a move out of the safety of cash and rates, in search of better yields elsewhere. This asset allocation shift is likely to have a big effect on markets, as some of the $6.6 trillion[1] currently stabled in money market funds is put to work. 

“For a long time, there was no opportunity cost to avoiding credit,” said Azhar Hussain, Head of Leveraged Finance at Royal London Asset Management. “Today, with yields of potentially over 6% and higher in the typically less risky parts of the high yield market, as well as the possibility for bond prices to rise if interest rates come down further, that opportunity cost is much higher.”

Richard Carter, Head of Fixed Income Research at Quilter Cheviot, also highlights the potential opportunity cost. “The problem with not owning credit is that you are giving up yield. If you don’t own a reasonable amount, you can find yourself missing out,” Carter noted. “We are generally underweight credit relative to benchmarks, because we think it’s currently expensive, but we still have a decent amount invested.”

Credit remains the riskier end of the fixed income spectrum and, despite a seemingly benign overall environment, it’s important to remember that the macro-economic picture is still far from clear. The wobbles in the bond market that followed the Fed’s 50bps September rate cut suggest that many think that central bankers might be over-optimistic in calling an end to the current inflationary cycle. 

Add to that geopolitical risk and the result of the US election, and it’s no wonder that many are wary of taking on too much risk going forwards. 

With much of the current soft-landing optimism already priced into the bond market, actively managing exposure will be vital when it comes to containing potential risks, while capturing yield going forward. 

The macro picture: Overall benign, but risks remain

Bond markets are now pricing in a number of rate cuts. This benign outlook is based on the premise that a soft landing is now largely assured, and that the current bout of inflation has been ended. 

But there are still two-way risks to this scenario. On the one hand, a resurgence of inflation can’t be ruled out. “The last bout of inflation was due to a combination of geopolitical uncertainty and the fiscal dislocations prompted by Covid,” Hussain said. “Today, geopolitical uncertainty is clearly rising, while fiscal risk, particularly in the US, is also fairly high. Taken together, those factors imply that we could well see a long-term higher-rate environment. It certainly seems unlikely that rates will return to the ultra-low levels that were once the norm.” 

At the same time, despite the market consensus, a hard landing remains a possibility, and all eyes are still on the US jobs market. Both the US unemployment rate, at 4.1%, and the number of unemployed people, at 6.8 million, are slightly higher than they were a year ago, according to September’s Bureau of Labour Statistics report.[2]

While keeping a wary eye on the numbers, Richard Carter sees the overall backdrop as fairly benign. “There’s been a lot of talk about recession, but so far the data indicates that the US economy especially is still resilient,” he said.

Hussain concurs that the chance of recession is smaller than it was a year ago, but stresses that risks still remain. “The shared view across the various fixed income desks at Royal London Asset Management is that the front end of the curve is the best place to be, because there is more certainty there,” he said.

Duration: Where to be positioned on the curve?

The relatively flat yield curve today means that, in both credit and rate terms, the front end offers yields that are comparable to those available at the longer end, where risks should in theory be higher. 

Source: Federal Reserve Bank of St. Louis
Past performance is not a guide to future performance.

​“The shape of the yield curve makes the front end more attractive on a risk-adjusted basis, and also means that investors can ultimately benefit more from nearer term rate cuts.” Hussain said. “Investors need to consider whether, as they go further out along the curve, they are getting paid sufficiently for the potential volatility.”

Quilter Cheviot has also pulled back in duration terms. “We were long duration earlier in the year, but we trimmed that back because we were a bit worried about the US election, and, potentially, the stickiness of inflation, although that concern is receding,” Carter explained. For lower-risk clients, Quilter Cheviot favours shorter duration bonds. “If you move two, three or four years out, you’re giving up quite a bit of yield versus what you can get on a six-month bond,” he said. “However, there remain very compelling opportunities in short-term low coupon gilts due to their tax efficient nature.”

Source: U.S. Bureau of Labor Statistics

Looking across the credit spectrum

One of the biggest questions investors face is where in the fixed income spectrum to invest. 

“Overall, we favour investment grade rather than high yield, because most of our clients have a balanced portfolio,” said Carter. “They already have exposure to global equities and to tech, so are looking to diversify that equity risk, while also capturing a reasonable yield.”

While high yield exposure is relatively low in Quilter Cheviot’s client portfolios, Carter still argues that there is a role for short-duration high yield. “There is a good yield available here, and then there is a degree of downside protection from the short duration exposure,” he said. “When things do go wrong, it doesn’t do as badly as the main market.”

Positioning: Spreads are tight, where’s the value? 

An important factor when it comes to positioning is the fact that spreads on credit have narrowed a lot over the last 18 months and are now extremely tight. “Across the core investable credit spectrum, there’s no getting away from the fact that spreads aren’t far from  levels we haven’t really seen since 2007,” Hussain said. 

This tightening is justified, he believes. Default risk on the global universe, even of high yield, is low by historical standards and getting lower. “If you look across global high yield default rates, they’ve come down quiet markedly over the last six to twelve months, particularly in the US,” Hussain explained. 

The technical reasons for this are the heavy flows of liquidity chasing an increasingly crowded market. This has been partly caused by the lack of fresh leveraged buyouts (LBOs) that have traditionally supplied the high yield market, as well as the expansion of private markets, which has reduced the stress on public markets. 

Justified or not, this doesn’t leave investors with much room for manoeuvre in terms of broader credit spreads. This is why the Fixed income team at Royal London Asset Management favours shorter duration. “You can still benefit from attractive credit spreads at this end, because the yield curve and the spread curve are so flat, particularly in high yield,” Hussain said. 

Taking advantage of mispricing

Another anomaly caused by the structural shifts in the short duration high yield space is what Hussain calls ‘temporal seniority’. This refers to occasions where subordinated bonds are due to mature before a senior bond. “The numbers show that defaults peak early in the life of a high yield bond,” he said. “Therefore, an approach that focuses on buying seasoned bonds in the secondary market can allow investors to structurally lower default risk in their portfolio.”

He believes this phenomenon is under-rated by credit ratings agencies. “Ratings are not driven by temporal factors, whereas in reality, these factors are a major element of the risk,” Hussain said. “That mismatch is at its most stark in high yield, and explains why the high yield credit curve is much flatter than it should be.” 

Source: Federal Reserve Bank of St.Louis

1. https://www.financialresearch.gov/the-ofr-blog/2024/09/25/ofr-monitor-shows-us-money-market-funds-remain-a-popular-parking-option-for-investor-cash/

2.https://www.bls.gov/news.release/empsit.nr0.htm#:~:text=Among%20the%20major%20worker%20groups,no%20change%20over%20the%20month

Past performance is not a guide to future performance. The value of investments and the income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. This is a financial promotion and is not investment advice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.