Is it worth buying bonds when cash rates are so high?
This is the question of the year and maybe of the years to come. Obviously, if you earn around 3 to 5% on deposit (depending on what country you live in), that's fantastic, as there's no risk. But the question you actually need to ask yourself is ‘how long rates can stay that high?’
Cash gives you high rates in the short-term, but they’re not going to stay this high for say the next 5 to 10 years. Alternatively, if you buy bonds, you can get this level of yield for a much longer period of time. By keeping your cash on deposit, you could be missing a huge opportunity to lock in this high level of yield (for a bit more risk) for the longer-term. In fact, buying bonds now could be highly profitable, particularly if we see interest rate cuts and / or a recession.
There are also other ways to take advantage of the fixed income market that are worth considering, particularly in shorter-maturity bonds, namely three to four years. For example, in short-dated credit, you can now get access to yields close to 7% in dollar terms. You’d have a bit of risk, but you will still be in high quality bonds and your investment here will be less affected by the path of interest rates.
How fast will higher rates hurt borrowers?
The fact that, so far, higher borrowing costs have not derailed the global economy, has surprised the market. We can see two stories at the moment.
In the US, most of the financing for corporates is done through the bond market, so they have been able to lock in very low yields in 2021 with relatively long maturities. This means that companies won’t need to worry about refinancing at higher costs for some time yet and why the impact on corporate financing from higher interest rates has been relatively limited so far. Similarly for US households who typically lock in mortgages for a 30-year term - and so are still enjoying low rates - the impact has been minimal.
It’s a different story elsewhere though. In the UK, where mortgage terms are much shorter households have had to re-finance at much higher interest rates. If they haven’t already done so, those people that borrowed at the very low levels in 2019 and 2021 will need to refinance very soon.
Across the eurozone there is less of a problem on the mortgage side, the problem here is on the corporate side, where much of the borrowing is through bank loans with variable interest rates. This means they are much more impacted by higher interest rates, and we are already seeing this show up in the economic data, with the eurozone suffering.
In comparison, the US economy is faring much better because corporates and households have so far been relatively immune to the rise in interest rates.
Could long-dated yields go even higher?
With the moves we've seen over the last two months, it's difficult to answer ‘no’ to this question. When you look at the economic data, it's clear that the resilience in the US has been impressive.
The key question is around the level of excess savings accumulated over the Covid-period. It’s clear that these savings have significantly contributed to the strength of the US economy. While there is some uncertainty around the level of these ‘excess’ savings now, we do know that they have been steadily declining over time so this ‘cash buffer’ is likely to be less of a support to the economy in the future.
But there's another factor that has stepped in recently – that’s the high level of debt in the US. We now see the ratio of government debt to GDP held by the public in the US getting to 120% over the next decade, a sharp rise since the pre-Covid period and the current level of close to 100% of GDP. The budget deficit has been running at 8% so far this year, which is a level you usually only see when the economy is in recession and unemployment is close to 7%, not 3.5% like it is now.
So in comparison to businesses and households, the US government is the only one really suffering from higher rates so far. It finds itself in a very negative loop: it has to refinance a substantial amount of debt in the short-term, as higher interest payments increase its deficit. Now the market is starting to understand this and is asking to be compensated for these risks through higher long-dated Treasury yields.
For these reasons we see yield curve “steepener” trades in the US as particularly attractive (that’s where we hold an overweight in shorter-dated Treasuries with a corresponding underweight in longer maturities). This is because the Federal Reserve is close to the end of its hiking cycle, but other drivers are less supportive for long maturity bonds.
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