Some of the biggest buyers in credit markets are calling the Federal Reserve’s bluff.
T. Rowe Price Group Inc., Allspring Global Investments and AllianceBernstein Holding LP are among investors seeking opportunities in longer-dated high-grade corporate bonds, reflecting bets that the peak in interest rates is nearing and a US recession would force policymakers to reverse course.
It’s a risky bet — one that has repeatedly hurt investors across financial markets over the past year — and it runs counter to Fed Chairman Jerome Powell’s view that borrowing costs may still need to go higher to tame inflation.
Dollar credits maturing in more than 10 years have gained 4.8% this year, three times what their shorter peers have made, a dramatic reversal from 2022 when the former lost a record 26%, Bloomberg indexes show. They expanded their total return premium over notes due in one to three years by another one-and-a-half percentage points from the end of May.
The stronger appetite for safer, longer debt offers the credit market’s perspective amid an ongoing debate over the Fed’s policy outlook after its latest pause on rate hikes. Underpinning the popularity of such bonds are their historically high yields and the assumption that they will benefit more when an economic slowdown prompts the central bank to cut rates.
“The market is betting that, over the next six months, as the economy slows and unemployment goes up, the tough talk is going to fade pretty quickly” by the Fed, said David Knutson, senior investment director at Schroder Investment Management. “And bottom line is that the market believes the Fed will cut and cut meaningfully, and that’s gonna drive long duration returns very positive.”
The Fed kept interest rates unchanged last week but warned of more tightening ahead. Investors holding different asset classes have reacted differently to the decision and policy rhetoric: while the S&P 500 enjoyed its longest winning streak since 2021 last week, the Treasuries yield curve deepened its inversion, an anomaly often considered a harbinger of recession.
Total returns on high-grade credit products tend to grow as the underlying sovereign yields drop. The relationship is weaker for junk notes due to greater default risks.
“We have been more comfortable to extend into duration and add gradually to that,” said Sheldon Chan, a portfolio manager for Asia credit at T. Rowe Price Group. “At the beginning of the year, we had a preference for shorter duration given the shape of the yield curve.”
Echoing a similar view, Brad Gibson, co-head of Asia Pacific fixed income at AllianceBernstein Australia Ltd., said adding duration on sovereign or high-grade credit “does make sense for us.” In a Bloomberg Television interview, he highlighted the euro and Aussie dollar markets, adding that there are also such opportunities in the UK.
Falling rates should drive returns on investment-grade bonds and adding duration should benefit portfolios when yields fall, according to Allspring Global in its mid-year outlook report, warning that “the opportunity cost of waiting for a perfect entry point is high and difficult to time.”
The thinking also goes that even if there’s an economic slowdown, longer-dated debt issued by strong-quality borrowers will become a sanctuary for more conservative investors. The strong earnings landscape across Corporate America further aids such optimism.
Narrowing Premium
Investment-grade dollar bonds have tended to deliver high single-digit or double-digit returns during the year the Fed cut rates and in the subsequent 12 months, with longer maturities the outperformers, Bloomberg-compiled data going back to 2000 show. For example, when the Fed eased policy in 2001 and 2019, such bonds returned 12% and 24%, respectively.
A notable exception is the 2007-2008 period when high-grade notes recorded losses despite monetary easing in the wake of the US subprime debt and the ensuing global financial crisis. Still, the bonds rebounded in 2009, with notes maturing in more than 10 years returning 19%.
“With the Fed still keeping to its hawkish stance that means the inflation expectations should ratchet lower over the medium term, so that will to a certain extent cap any rise in long-end bond yields,” said Chang Wei Liang, a strategist at DBS Bank Ltd. “Investors should be looking at extending duration.”
But not everyone is convinced. Pictet Wealth Management, for one, said it sees no reason to extend duration much for investment-grade credit.
“We do not go beyond five years as we think that the additional duration risk is not correctly remunerated,” according to Alexandre Tavazzi, head of Pictet’s chief investment office and macro research. “This is valid for all currencies.”
The extra year-to-date return on dollar bonds due in more than 25 years over those maturing in one to three years is 3.6 percentage points, compared with a high of 21 percentage points in 2019.
T. Rowe’s Chan also cautioned that exploring opportunities in longer debt doesn’t mean aggressively adding duration, citing the risk of further market volatility and “good short-term carry” opportunities.
However, as New Zealand entered a recession after leading the global monetary tightening cycle, the room for policy complacency may start to shrink.
“This a good entry point for investment-grade bonds, especially to lock in the more attractive yields and even to think about to extend duration,” said Grace Tam, chief investment advisor at BNP Paribas Wealth Management in Hong Kong in a Bloomberg Television interview. Even if delayed until next year, “the recession in the US is still our base case scenario,” she said.
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