Opportunities in short duration government and investment grade bonds

Written by Mauro Valle, CFA , Head of Fixed Income at Generali Investments Partners

Long-term bond investors may want to consider capturing positive yields in short duration government bonds and investment grade credit. This is partly due to the uncertainty of the current environment.

While the market is pricing further rate hikes from the ECB this quarter, financial markets are still unsure about where the final level of yields will settle, particularly on the short end of the curve.

This uncertainty is due to two big question marks around inflation and growth, the central factors that drive bond pricing: Will inflation continue to decline or pick up again? Will we have a global recession and how bad will it be? In my view, inflation should start to decline at the beginning of 2023, although the speed of the decline is uncertain.

This will depend on next quarter’s growth: the economy will certainly be weaker but the magnitude of the slowdown is not yet clear. This trend could also impact the next consumer price reports, especially core CPI.

If clearly weaker growth combined with declining inflation forces the ECB to end its hiking cycle, investing in the short end of the yield curve therefore presents an opportunity for long-term investors to lock in attractive yields.

Long-term bond investors may want to consider capturing positive yields in short duration government bonds and investment grade credit.

In the (central) case of a peak in inflation over the next few months and a subsequent decline, the ECB will probably have to continue to hike but in the first few months of next year they will have to pause.

So while current yields may not reflect peak inflation, the level of compensation offered for the risks are now starting to be positive, and we are entering market valuations in which we consider short duration credit cheap from both a historical and relative perspective. We therefore believe that investments in the short end of the yield curve are not to be dismissed.

We are in the final phase of the hiking cycle and the impact of higher rates are now amortized by the carry of investing in the short-medium maturities of government and corporate bonds.

In terms of short duration government bond opportunities, considering Bund spread levels, we favour debt issued by peripheral European countries. Italian bonds are consolidating after recent political events and the focus of the next few months will be more about growth than political?risk.

In addition, investment grade credit with medium maturities provide an attractive risk-reward, given they are pricing in recession risk much more highly than equity and high yield, while offering greater resilience to default risk.

In terms of short duration corporate bonds, we favour financials and hybrid subordinated bonds offering high ?single digit yields, from resilient investment grade issuers with strongbalance sheets and easy access ?to financing from financial markets.

In contrast to the conditions of the last 20 years, the risk-reward payoff in investment grade now presents a potential total return opportunity.