Seizing Income Opportunities as Central Bank Tightening Peaks

An alluring entry point for income seekers

Income-seeking investors should prepare to identify entry points as central banks’ policy tightening peaks. As we are entering into a volatile environment, balancing duration and credit risk will be pivotal. Moreover, as uncertainty keeps volatility in bond markets elevated, our preference is to keep duration at a minimum.

Short duration markets, which are the most sensitive to central banks’ policies, offer above-average income opportunities. Even if rates rise further in the near future, the yield offered by high-grade bonds is enticing for buy-and-hold-investors. The spread offered by investment-grade corporates with maturity between one to three years over the US Treasuries is 62bps, paying an average yield of 5.04%. According to the Bloomberg US Aggregate Bond Index, that’s the highest yield paid by high-grade bonds with such short maturity since 2007. More strikingly, IG corporate bonds with one to three years’ maturity offered an average yield of 1.8% from 2007 to today.

Similarly, high-grade euro corporates with one to three years of maturity pay 4.43%, the highest yield since the 2011 European sovereign crisis, paying 280bps over the past fifteen years’ average.

The yield offered by corporate bonds in the UK is much higher than in the United States and Europe. Although for buy-and-hold investors further BOE rate hikes might not represent a threat, it’s important to note that credit risk in the UK is higher than anywhere in developed economies due to uncertainty surrounding inflation and future monetary policies agenda. Thus, cherry picking in this space is even more critical.

 

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Not only corporate bonds offer enticing returns

Recent government bond issuance shows that risk-free alternatives to the corporate bond market or even stocks offer good opportunities. In June, the UK debt management office (DMO) sold five-year notes with a coupon of 4.5% and a yield of 4.932% (GB00BMF9LG83). That’s the highest coupon offered on five-year notes since 2012, and the highest yield since 2008. Similarly, the US Treasury issued two-year notes in June with a coupon of 4.25% (US91282CHD65). Also, the German Bund sold in April (DE000BU3Z005) pays a coupon of 2.3%. That’s quite staggering if we think that a few years ago, it would have paid a coupon of 0%, providing a negative yield to investors.

 

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Artificial Intelligence and the bond market: the great deflation

In an AI economy, increased productivity and job displacement will exacerbate income inequality. It translates into bigger fiscal deficits as governments initiate education initiatives and social safety nets. As unemployment rises and inflation drops, monetary policies will become more accommodative, with the possibility of negative rates becoming the norm. Yet, the new regime will come with increased inflation volatility. To avoid that, policy makers will be incentivised to regulate AI and use it selectively in order not to destroy the real economy, producing milder economic effects.