The rise in interest rates has aroused the interest of many towards fixed income investing. The time is now ripe to invest in fixed income, but it is worth placing your money in short or long maturity investment targets. What should be kept an eye on for the rest of the year as interest rates continue to move?
For fixed income investors the current market environment is especially favorable for short maturity corporate bonds. That’s because in a market with longer maturities and higher interest rate risk, such as government bonds, fluctuations in market interest rates have a strong impact on returns. In addition, pricing is also attractive in the Investment Grade market despite the higher interest rate risk.
Right now, we prefer corporate bonds because in a historical context they give investors good compensation for credit risk in both Investment Grade and High Yield markets. Despite the volatility of recent months, the fundamentals of the corporate bond market are very similar to those at the start of the year: companies' balance sheets are in excellent shape, and they have managed to protect their margins by passing on rising costs to selling prices. Also, for this year, the companies have low refinancing needs.
What is most compelling for fixed income investors – and especially corporate bond investors – in today's pricing is the attractiveness of the prevailing yield level, for example when the yield level of the Investment Grade market exceeds the dividend yield of the equity market. The yield level provides the fixed income investor with significant protection against volatility as the high carry return over the course of the year provides a good buffer for any fluctuations in interest rates and credit spreads.
Markets are pricing in more rate hikes in Europe, but at the same time a recession is expected to come thereafter, which has turned the yield curve inverted. This means that investors are getting higher carry returns on shorter maturities than on longer ones, making short dated corporate bonds more attractive, while there are also enticing long-term returns available for corporate bond investors.
”Pull-to-par” -phenomenon an important component of returns
Credit spreads on short-maturity bonds are around the same levels as during the first wave of the coronavirus pandemic in late summer 2020. This despite the fact that corporate balance sheets are significantly stronger than pre-pandemic levels and there are less near-term maturities.
This provides clear benefits for corporate bond investors. Short-maturity corporate bond investors can enjoy the so-called pull-to-par phenomenon, whereby the price of the bonds rises towards 100 (par) at maturity even if there is no change in the yield level.
Fixed income investors should remain vigilant for the rest of the year
There are plenty of things for investors to watch for the current year. For example, it’s worth observing how much more central banks will raise interest rates, whether a recession will come and how bad it will be. And of course, there are the geopolitical developments in general to take into account. All of these will have an impact on sentiment and risk pricing.
I believe that we will experience further periods of high volatility during the year. In an uncertain environment, short-dated investments with moderate interest rate risk and credit risk offer a very attractive return opportunity with yields above 5%. The key is to keep an eye on the horizon and, instead of focusing on short-term market volatility, seek the high carry returns that the market offers over the one-year horizon.
Juhamatti Pukka
