DM IG: Play Defense

Despite the hawkish surprise with the Fed projecting only one cut this year (US Inflation, Fed Meeting Both Surprise), UST yields declined meaningfully following weaker than expected inflation data. Month-to-date (MTD), the 2Y UST shed 12bps to 4.75%, while the 10Y declined 23bps to 4.27% currently.

The main message from the Fed’s latest Summary of Economic Projections (SEP) was that disinflation remains on track but with a delay. As such, the timing of cuts was pushed back, but the total number of rate cuts remained the same. A slower start to the cutting cycle and a gradual easing reinforces the view that interest rates will remain higher-for-longer.

The collapse in UST yields resulted in lower all-in yields in DM IG, from a peak of 5.8% in early May to 5.47% currently. Spreads in DM IG have been inching towards their tightest levels in decades. While valuations in corporate bonds looks expensive by historical standards (gauging by spreads), we think this is largely warranted and aligned with fundamentals.

However, with spreads now so tight, we see limited room for further compression over the near-term. Hence, near-term performance is likely dominated by rates, given a substantial ~80% of DM IG’s total yield contributed by the rates component.

The recent weakness in macro data and the latest inflation readings are consistent with our view that the US is headed for a soft landing; which will permit the Fed to deliver two rate cuts this year – the first most likely occurring in the September meeting. The futures market is currently pricing in about 45bps of rate cuts for this year – more than the recent dot plot, but roughly in line with our house view.

As such, for rates to continue outperforming from this level would require a very good inflation print or a material weakening in the labour market.

Conversely, there are some headwinds that could impact the outlook. The first US presidential debate is scheduled on 27 June and would likely renew a market focus on concerns surrounding fiscal, trade and immigration policies which could impact inflation, driving UST yields higher from here.  

The current tight level of spreads, coupled with a decline in yields provides less cushion, making DM IG more vulnerable to volatility. Hence, we think investors should stay selective and raise the defensiveness in the fixed income portfolio. We think the front-end provides more buffer against rates volatility given the higher yield-to-duration cover.  

This article was first published by Bank of Singapore on 20 June, 2024. The Opinions expressed in this publication are those of the authors. They do not purport to reflect the opinions or views of OCBC Private Bank or its affiliates.