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Bonds

March 2024

Holding out for a rate cut

With their higher duration, US Investment Grade bonds and US Treasuries should be best placed to benefit from falling Treasury yields in 2024, and we reiterate our Overweight on these asset classes.

Vasu Menon,
Managing Director,
Investment Strategy,
Wealth Management Singapore,
OCBC Bank

The overall trajectory of the Federal Reserve’s (Fed) rate policy has been the primary driver of fixed income markets in recent months, and we expect this trend to continue in the near term.

Developed Markets (DM) Investment Grade (IG) bonds and US Treasuries (USTs) should be positioned to achieve solid returns in anticipation of this year’s declining interest rate environment, and we therefore accord these asset classes Overweight recommendations.

However, a Fed pivot and the resulting declining interest rate environment should be beneficial for fixed income broadly. Hence, we are Neutral DM High Yield (HY), Emerging Markets (EM) IG and EM HY as well.

Rates

While Fed rate cuts are on the radar, the key question remains about the pace and timing of rate cuts. From pricing in sharp 165bps of rate cuts in mid-January, the market has scaled back expectations. In addition, the market has also pared back sharply the odds of the first rate cut at the March meeting which stood at 90% in late December. Despite that, the current pricing still looks excessive against our expectations for 75 basis points (bps) of rate cuts for this year, with the first reduction in June.

While progress on inflation allows for lower fed funds rates this year, the robust labour market and strong economic growth suggests that the Fed will likely not rush into cutting rates at the pace that the market currently expects.

The US Treasury’s latest borrowing estimates shows smaller issuance needs for the first half of the year, tempering supply fears. In particular, the US Treasury guided US$760b for the January-March quarter (US$55b below previous estimates) and US$202b for April-June quarter. The lower issuance needs will provide a supply relief and be supportive of the rates outlook.

Given the resilience observed in economic activity in the US and the persistence of services inflation, the Fed and market participants are in a wait-and-see mode until there is further confirmation of the disinflation process. This has led the market to pare back their pricing of 2024’s cuts quite materially in the past month.

The market is now pricing in about 80bps of cuts against about 160bps of cuts at its peak. A March cut has been fully priced out and from June onwards, there is now about a 60% chance of a 25bps cut at almost every meeting. This has led to an upward correction in UST yields.

With markets having significantly pared back cuts this year, further repricing towards fewer cuts now looks unlikely. Given the US’ disinflation is well underway and the prospects for the fed funds rate to be lowered this year are high, we maintain our preference in long duration.

Developed markets

The current pause in anticipation of Fed policy easing in mid-2024 drives our Overweight recommendation on DM IG. With tight spreads near post-GFC levels, rates are now the primary driver of returns for DM IG. Given our expectations of demonstrably lower UST yields by the end of 2024, DM IG should be well-placed to benefit given that they possess the highest duration of the credit classes. Rate cuts should also result in a move out of money market funds (reversing 2023 trends), as investors look to lock in yields in anticipation of declining rates. Within DM IG, we maintain a preference for the US versus Europe.

Emerging markets

We maintain a Neutral rating on EM HY and EM IG with a preference for the former. Favourable top-down factors including declining rates and a waning USD should underpin performance. Additionally, after two years of elevated defaults, we expect 2024 to return to levels that are more indicative of long-term averages with lower distressed levels validating this trend. Finally, the EM HY space has also become more geographically diversified over the past several years, which should mute volatility going forward.

Asia

We maintain a Neutral rating on Asia IG and HY and continue to monitor China’s economy for any sign of bottoming. The property sector has seen stronger stimulus such as the 5Y loan prime rate  cut and the channelling of funding to stalled projects including those of defaulted developers. On the other hand, the sector continues to be marred by weak sales and risks of liquidation for defaulted developers, with Country Garden being the latest to face a winding up petition.

Within the Indian HY space, we like renewable energy names as the sector stands to benefit from an increasing share of renewables in the country’s energy mix over time. The renewable energy names that we like have sustainable capital structures and adequate liquidity positions. Within India IG, we like quasi-sovereign names and good quality credits with strong balance sheets.

In Indonesia, with Prabowo Subianto appearing to lead the presidential election vote, we expect a continuity of President Jokowi’s policies such as metal down-streaming and the construction of the new capital city, albeit with a potentially looser fiscal stance. Key upcoming events to watch will be the parliamentary seat count of the Prabowo-Gibran coalition and the cabinet line-up, particularly in economic-oriented ministries. Clarity on the new administration’s fiscal policies and energy subsidies will also be crucial for the sovereign and quasi-sovereign bonds. The relatively longer duration of the Indonesian IG segment could also see more volatility amidst market repricing of Fed rates trajectory and mixed US economic data.

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