Stay agile while seeking revenue | Private Equity Weekly

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Central bank interest rate hikes restored fixed income yields. We see this continuing even as rate cuts are underway.

We remain selective on fixed income and credit in the second quarter.

1)A new regime

As central banks raise interest rates during the pandemic, it puts income back into fixed income.

We believe interest rates will remain high for longer. We believe sticky inflation will limit the extent of central bank interest rate cuts and drive down bond yields. This is especially true in the United States, where inflation looks set to pick up again and stabilize above the Fed’s 2% target next year.

2) Tactical perspective

We remain selective in updating our tactical view for the second quarter. We favor short-dated government bonds and emerging market hard currency debt. We are underweight investment grade credit, where spreads remain tight.We think other Assets better compensate for risk. That’s why we like high yields, especially in the Eurozone.

3) Strategic perspective

From a five-year and longer perspective, our strongest view is that we are overweight inflation-linked bonds due to ongoing inflationary pressures.

We are also strategically underweight long-term bonds. We believe that over the long term, yields will rise as investors demand more term premium or compensation for the risk of holding long-dated bonds.

This is our market view

We remain selective, favoring short-dated government bonds, euro area high-yield credit and emerging market hard currency debt.

Yields jumped as central banks raised interest rates to record highs, ushering in a new era of fixed income. Even with an imminent rate cut, we believe yields will continue to rise. We believe central banks will keep interest rates higher for longer than pre-pandemic due to ongoing supply constraints. While incomes have recovered, tighter U.S. credit spreads and volatile long-term yields pose risks. We remain selective in fixed income and credit as we begin the second quarter. We like hard currency emerging market debt and high-yield credit.

no more negative emotions

Market value of global negative yield bonds from 2010 to 2024

For a decade, as central banks slashed interest rates and bought bonds to ease policy, negative-yielding bonds flooded global markets, with key global bond indexes soaring to more than $18 trillion at their peak. See chart. Negative yields are now a thing of the past—a huge shift for fixed income markets. After the outbreak, central banks around the world raised interest rates to curb inflation, and yields hit record highs in decades. Among them, the U.S. 10-year Treasury bond yield hit a 16-year high last year. We had expected a spike in long-term yields – remaining underweight on both a tactical and long-term basis for a few years before turning tactically neutral last year. We believe interest rates will remain higher for longer due to the stickiness of inflation, limiting the extent to which central banks can cut interest rates. Higher interest rates mean bonds provide more of a cushion of income. However, greater macro volatility has hindered their ability to offset the sell-off in risk assets. That’s why we remain selective on fixed income.

Given continued volatility in long-term bond yields and tighter US credit spreads, we would choose a tactical horizon of 6 to 12 months. We are neutral on high-yield credit and find overall yields in riskier asset classes more attractive than investment-grade (IG) credit, where spreads have narrowed more. Returns on high-yield credit are also less sensitive to increased interest rate volatility. Moody’s data shows that while default rates have increased since 2022, they appear to be stabilizing. We prefer euro area high yield bonds as spreads have not tightened as much relative to the US. In this environment, our risk appetite stance underpins our preference for high-yield credit over investment-grade bonds, and favors equities over bonds. However, investment-grade credit may be attractive to investors focused solely on fixed income, as we do not expect spreads to widen significantly this year.

Become fine-grained across horizons

In our other views, we also remain flexible and nuanced at the regional level. For example, we prefer emerging market (EM) hard currency debt (primarily issued in USD) over developed market government debt. Emerging market hard currency debt spreads have also not tightened as much as overall euro area and U.S. credit spreads. We have seen the recent macro backdrop become more conducive to risk-taking behavior, with some emerging market central banks cutting interest rates as inflation cools. When it comes to inflation-linked bonds, we prefer U.S. Treasuries. Now, with market inflation expectations falling as we expected, we upgrade Eurozone inflation-linked bonds to neutral.

How do our views differ on strategic horizons of five years and beyond? We are overweight developed market inflation-linked bonds – and prefer them to longer-dated government bonds – due to persistent inflationary pressures. We maintain our tactical and strategic preference for short-dated bonds. We believe long-term yields will rise as investors demand more compensation for the risks of holding long-term bonds given record debt loads and swelling bond supply. When it comes to credit, we prefer private to public. We see demand for private credit increasing as banks scale back lending and yields better compensate for risk than public credit. The private equity market is complex, risky and volatile, and is not suitable for all investors.

our bottom line

Higher interest rates have ushered in a new era in fixed income. We remain selective in updating our tactical view for the second quarter. We prefer short-dated government bonds, euro area high-yield credit and emerging market hard currency debt.

market background

The S&P 500 closed the first quarter at a record high last week. The index rose 10% in the first quarter even as bond yields rose as the market priced in interest rate cuts. The U.S. 10-year Treasury yield was essentially flat, settling near 4.20%. Japanese stocks retreated from record highs as the yen fell to a 34-year low against the dollar. The Bank of Japan ended negative interest rates last month in a bid to normalize policy rather than concerns about inflation, causing Japan’s 10-year government bond yield to fall further.

We’ll be keeping a close eye on this week’s U.S. jobs report to gauge whether job growth will continue to surge due to increased immigration. Over the longer term, we believe that with an aging population and no further boost from immigration, the United States may be at risk of a structural slowdown in labor force growth (a key production constraint).