Fixed income investors are bracing for a challenging second half of the year, as rising interest rates drag bond returns deeper into red territory.
Bond returns took another beating in the three months to June, according to Morningstar Manager Research, as global central banks stepped up interest rate rises in a bid to rein in rampant inflation.
The US Federal Reserve raised interest rates by a total of 125bp between May and June and delivered its second 75bp interest rate increase last week, taking its benchmark rate to a range of 2.25%-2.5%. The European Central Bank reacted by scaling back its bond-buying programmes and ended eight years of negative interest rates at last month's meeting.
Surging US interest rates crushed fixed income returns, while Russia’s invasion of Ukraine turbo-charged the global inflationary trend, sending food and energy prices soaring across Europe.
Losses on the euro government bond, euro corporate bond, and euro high-yield bond Morningstar Categories ranged from 10% to 14% since the beginning of the year through to the end of June, it said.
The pain was felt evenly as higher borrowing costs combined with mounting fears that central banks may trigger a recession to bring down inflation from multi-decade highs led to a broader-based sell-off.
“Amidst twin fears of rising rates and an economic slowdown, European bond investors have shunned safe-haven and risk assets alike,” Morningstar said.
The sell-off in European credit markets led to significantly wider spreads in corporate bonds, causing funds with a more pronounced tilt to this asset class to struggle across the board.
The ICE BofA Euro High Yield Index offered a yield close to 7% as of the end of June 2022, with such yield levels reminiscent of those in the early days of the coronavirus sell-off and in 2012, when markets were recovering from the European sovereign debt crisis, it said.
Real estate topped the worst-performing industry sectors for both investment-grade and high-yield corporate bonds, as the sector is highly sensitive to both cooling economic forecasts and higher interest rates. It was followed by energy, as Western sanctions on Russia weighed.
Investors in green bond funds did not emerge unscathed. Almost 30 of a subset of 70 green bond strategies analysed by Morningstar ranked in the bottom decile of their respective category so far this year, including Shares Green Bond Index (IE) Instl.
“These vehicles tend to be more rate-sensitive and also exhibit a corporate bond bias, a deadly combination in the current market environment,” it said.
Funds focused on inflation-protected bonds held up slightly better, though still recorded losses. The typical fund in the euro inflation-linked bond category lost 3.9% over the period given the structurally long duration of the inflation-linked bond market, Morningstar said.
However, many bond managers on both sides of the Atlantic argue that both investment-grade and high-yield corporate credit is becoming more attractive at current valuations, though some sectors will likely stay under pressure.