By Robert Tipp, CFA, Chief Investment Strategist and Head of Global Bonds, PGIM Fixed Income
As expected, after the strong interest-rate rally in the fourth quarter of last year, the market was due a rest. Indeed, the longer-duration and higher quality segments of the bond market registered negative returns in Q1. However, the rally in credit products powered ahead thanks to stable fundamentals and strong demand from retail, pension, financial, and overseas investors.
Indeed, the demand for yield was so strong that the higher risk segments of the market, such as high yield corporates and hard currency emerging markets, posted strong positive returns despite the increase in government yields. And although the tightening in investment grade spreads was far more modest, it was impressive nonetheless as it occurred in the face of record supply.
Is there too much cash?
In general, the strong bond inflows and the sharp rally in higher-risk fixed income has not happened in a vacuum, but rather against a backdrop of rallying prices for a range of asset classes from gold to crypto currency to AI stocks. While one can make the case for any of these bullish stories, perhaps there is a powerful contributing factor: investors have too much cash.
Some of the buoyancy in assets ranging from stocks, bonds, and gold to crypto currency may be from investors paring back uncomfortably high cash levels. Based on the ratio of US money market assets to nominal GDP, 21% is historically high, and long bull markets in credit products have started from points in time with similarly elevated ratios.
In absolute terms, money fund assets soared during the pandemic. They surged again as savers at first sought safety and then higher yields in money funds following the SVB blowup. Compared to the roughly 15% of nominal GDP invested in money funds during more placid times, the current level of 21% is more akin to the highs of the 2002 and 2008 recessions – both of which were followed by strong, multi-year rallies in stocks and a generally favorable environment for credit products as well.
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While investor allocations to equities and real estate may have increased via appreciation and cash allocations increased through flows, bond allocations may have been depressed by the rate increases over the past few years. This seeming imbalance in allocations – running counter to an ageing demographic – suggests that bonds could remain well supported if and as investors try to rebalance towards more normal/higher fixed-income allocations.
In the “lower interest rates are coming, a soft landing is in the bag, AI will save the world, and do not bother me about geopolitical risk” category, stocks have nearly doubled from their pandemic lows with half the rise occurring in practically a straight line over the last several months.
Alternatively, in the “hedge against geopolitical risk” category, gold has catapulted to new highs, up 25% since early October as tensions have risen in the Middle East. Lastly, the SEC has unleashed a new pool of investor capital on the crypto currency market by enabling crypto ETFs, and over the last six months, the prehype and kick-off of the ETFs has driven a doubling of bitcoin.
Where to from here? High yields generate return
Ever since the fall of 2022 when 10-year yields broke above 4% for the US Treasury, investor demand has suppressed long yields, causing an inversion of the yield curve as cash rates continued to rise. While many assumed this was a sign of a looming recession, alternatively, it may simply reflect investors’ recognition that yields are back at generational highs.
And as the markets have progressed since the fall of 2022, central bank rate cycles have peaked, adding a sense of urgency on the part of aging investors, pension funds, and financial institutions to get into the bond market at the peak of the rate cycle.
Looking ahead, the outlook for bond market returns over the long run remains strong. While we do not expect a decline in long-term yields, today’s still generous yield levels will nonetheless continue to accrue.
Similarly, although wholesale spread tightening from current levels is unlikely, spread sectors can add incremental income and return as well as offering opportunities to add value through sector rotation and issue selection. One possibility is that the rally’s laggards catch up, potentially resulting in spread compression across the quality spectrum.
In the higher risk markets, such as high yield and emerging markets, investors have finally turned their attention to the laggards: the lower credit quality realms. That leaves room to add value by playing for narrower spreads by quality, through tactics like a credit barbell, or issue selection in stressed/distressed credits.
All told, long-term rates and credit spreads are likely to remain relatively range bound, with some potential for narrowing of credit spreads and favorable avenues for adding value through active management as the current high yields transform over time into realized returns.
