Rising oil prices and adjustments in global equity markets are capturing investors’ attention; however, investment firms are urging investors to watch what is happening in the fixed income market, especially with bonds. Since the start of the war between the U.S. and Iran at the end of February, the bond market has behaved in an unusual way for a geopolitical conflict.
According to experts, it is striking that instead of clearly acting as a safe haven, bonds have experienced selling pressure and their yields have risen. For example, the yield on the 10-year U.S. Treasury exceeded 4%, driven by rising oil prices and inflation expectations. Normally, during geopolitical episodes there is a “flight to quality,” meaning investors buy sovereign bonds as safe-haven assets. However, this time the opposite has happened because inflation risk has weighed more heavily than the safe-haven effect. Some analysts have even noted that the bond market “is not functioning as a safe haven” in this episode.
Bond Market Behavior
“In the case of sovereign bonds, the most common pattern during periods of geopolitical tension has been a decline in yields due to demand for safe-haven assets. This was the initial reaction following the announcement of the military operation. However, yields subsequently rose throughout the week. With the exception of Japan, the main government debt markets have experienced a bear flattening so far this month, with short-term yields showing significantly worse performance. The so-called ‘bond vigilantes’ could argue that this reflects the increasingly fragile state of public balance sheets, given the high level of debt and ongoing fiscal expansion, which could undermine the traditional role of sovereign bonds as a store of value during periods of global uncertainty,” explain experts at Muzinich & Co.
Daniel Loughney, Head of Fixed Income at Mediolanum International Funds (MIFL), agrees that, so far, sovereign debt has shown the weakest performance, as inflation concerns have led to the dismantling of expectations for interest rate cuts. “In fact, the ECB is now expected to tighten monetary policy by around 50 basis points. As a result, short-term bonds have been the most affected, while longer-maturity bonds have suffered less,” he notes.
In the view of Luke Hickmore, Chief Investment Officer for Fixed Income at Aberdeen, the reason for this behavior is that the bond market is highly focused on the problems that could arise from rising hydrocarbon prices, particularly the impact of natural gas prices in Europe and the United Kingdom. “U.K. government bonds have performed very poorly during this period, with the yield on 10-year bonds rising by around 0.5% during this conflict, and shorter-dated bonds are now moving to price in an interest rate hike by the Bank of England in June.”
For their part, Adam Hetts, Global Head of Multi-Asset, and Oliver Blackbourn, Portfolio Manager at Janus Henderson, explain that concerns about rising European inflation—or simply prolonged stickiness in the United States—would explain why bond yields have increased. “Yields on U.S. Treasury bonds have risen as markets have priced out one of the interest rate cuts by the U.S. Federal Reserve that had been expected for the end of the year. Yields on 10-year Treasuries have moved less than their European counterparts, as Friday’s U.S. employment figures helped offset part of the upward pressure on yields stemming from expected inflation,” they note.
A Look at the Credit Market
In contrast, since the conflict between the U.S. and Iran began, investment grade credit has not significantly reflected economic tensions in prices. According to market reports, spreads have moved slightly but continue to reflect the excellent fundamental quality of most large companies in this environment.
“That is likely where the risk lies in the coming weeks: if oil and gas supply issues persist, which have a lasting negative impact on corporate quality, corporate credit is likely to underperform expectations. In recent months we have favored higher quality in credit markets, reducing risk and holding more cash than we normally would. It is not yet time to put that cash to work,” explains Hickmore.
Muzinich & Co acknowledges that total returns in credit markets are lower so far this month, although, interestingly, high yield has slightly outperformed investment grade credit. “In fact, a European investor positioned in U.S. high yield without currency hedging would probably be quite satisfied with that investment decision so far this month.” As for riskier assets, the U.S. asset manager expects credit spreads to widen.
The Conclusions
After this quick analysis of both markets, according to Luke Hickmore, Chief Investment Officer for Fixed Income at Aberdeen, what is happening is clear: “The increase in government bond yields is doing part of the heavy lifting and has prevented credit spreads from widening as much as we might have expected before the conflict began.”
Despite these unusual dynamics, Loughney argues in favor of staying invested and says conservative investors should not overreact. “Much of the downside risk has already been priced in under the assumption of a prolonged conflict. Any sign of resolution in the coming week could trigger some reversal of last week’s moves, from which investors could benefit,” he says.
Investment firms argue that the escalation of geopolitical risks has occurred at a time when inflationary pressures have been steadily moderating worldwide. As a result, they explain, over the past 12 months there have been more signs that fixed income can act as a counterweight to weakness in equity markets. “Central banks are likely to look through the brief spike in energy and commodity prices in general. However, a prolonged conflict that increases the likelihood of a sustained rise in oil prices will raise concerns about increasingly entrenched inflation. It is this secondary effect—if inflation expectations become unanchored—that could worry central banks. For now, we see some short-term upside risk for yields, but still within the recent trading range. Recent developments reiterate the need to actively manage fixed income portfolios, not only to take advantage of opportunities but also to protect against downside risks. As always, diversification remains key,” argues James Ringer, fund manager at Schroders.
