By Octo AM

Last week, we advised our readers to be nimble in their bond choices in order to get the best out of the market, currently torn between hopes of rate cuts already widely priced in, fears about the economic situation, heterogeneous earnings and outlook publications, weighing political and geopolitical issues and, more generally, the shift from a preoccupation with inflation to a preoccupation with slowdown, or even recession… all elements conducive to high volatility on rates and the “corporate premium”, represented by the credit spread on the bond market or equity prices. all elements conducive to high volatility in rates and the “corporate premium”, represented by the credit spread on the bond market or share prices. This chart of the trend in German 10-year yields over the past few days, and this one of the trend in the Stoxx 600, bear witness to this.

(Sources: Bloomberg, Octo AM)

Traditionally, it has been said that when the “corporate” premium deteriorates, the “interest rate” component improves, which theoretically makes the bond market extremely stable and inversely correlated with the market for risky assets, in particular equities. Today, however, this argument is no longer necessarily valid – although it may be, and that’s the crux of the difficulty – for the following reasons:

1. The pressure of central bank balance sheets on the bond market
2. The interplay of central banks’ and markets’ increasingly advanced monetary policy forecasts
3. The sheer volume of liquidity involved, spread across the globe and among investors with a plethora of constraints and objectives: a Chinese domestic investor investing in a European bond ETF, for example, will not do so for the same reasons as a French insurer or a Swiss private banker… the former will focus primarily on capital security, geographic diversification and currency; the latter on regulatory, accounting and relative performance issues compared to other asset classes.
4. The importance of derivatives and pure speculation in setting interest rates beyond three months and, to a lesser extent, credit premiums.
5. The importance of ETFs in bond outstandings – between 80% and 90% of the market – despite the fact that they are weighted in almost the opposite way to the traditional risk/return ratio, since they favor issuers with the most debt…

What’s more, these elements lead to a number of rather counter-intuitive findings and conclusions for investors, either because they run counter to economic and financial history – but aren’t we, when it comes to indebtedness, in territory never explored by history? – or because they go against the grain of many articles, most of which are based on reasoning that is valid for other asset classes, but do not take into account the specific nature of bonds.

1. Just because the FED is slowing the pace of rate cuts doesn’t mean the ECB will; and it would be quite possible to see a lasting interest rate differential of 2% to 3% between the Eurozone and the USA over the coming years. For this to happen, the two institutions would have to diverge in their actions, since the gap today is only 1%. There are two explanations for this: firstly, economic dynamism, and secondly, the difference in mission between the FED, which monitors the economic statistics of a single country, and the ECB, which monitors the statistics of some fifteen countries and also ensures that the political balance of the alliance of these countries is preserved.
2. It’s not because short rates will fall that long rates will fall: for two years now, investors have been massively anticipating central bank rate cuts by positioning themselves in long bonds. This has led to an inverted slope, mechanically resulting in a significant relative outperformance of long bonds compared to short bonds. Some will say, “They have underperformed over the past 2 years”… True, but that was still too much, and current market expectations of 6 to 7 rate cuts on either side of the Atlantic by the end of 2025 offer little room for manoeuvre and outperformance on high-quality long bonds.
3. It’s not because key rates are falling that funds will perform, or more precisely, that “all” funds will perform. There are three reasons for this:
   1. The aforementioned market expectations have rendered many curve points “fairly priced”, if not overvalued. A reversal of these expectations, or even their mere realization, would not offer any outperformance over shorter or more creditworthy bonds.
   2. The fact that up to 70-80% of a bond’s performance can come from the corporate component, which is not directly linked to base interest rates, let alone the policy rate.
   3. Key rates are administered, and long rates depend on supply and demand. So, in addition to the factor of a falling 15-day rate (the ECB rate), which can compress the curve through the effect of discounting, there are many other factors: a falling money supply, deteriorating public finances leading to a rise in the cost of sovereign risk (in the case of France) and an increase in debt requirements, geopolitical tensions with buyers of American and European debt (China), etc.
4. It’s not because corporate quality is improving that all bond funds will perform well: remember that the bulk of the bond market is made up of ETFs or similar vehicles, which weight their positions by the amount of debt in circulation. This creates two major biases that are totally unsuited to efficient management:
   1. All other things being equal, the riskier a company is, the more its bonds are bought by bond ETFs, de facto lowering their returns and thus the risk/return ratio. An ETF will thus increase its bond positions in companies that are deteriorating, and reduce those that are improving…
   2. Sectoral biases often emerge as crises unfold: for example, at the end of 2020, the most heavily weighted sectors were airlines and tourism, and today it’s telecoms and automobiles… Altice was once one of the index’s top issuers, as was General Motors…
   3. A few huge debt mammoths generally account for 25% to 30% of the index in the high-yield or financial segment, which creates relative diversification for the investor.
   4. Finally, we mentioned above that the choice of investment maturity (the curve point) is important for the investor. However, an ETF will not choose the curve point according to the investor’s interest, but simply according to the deposit. Given that the deposit is issued by corporate debtors, the average maturity of an ETF is determined more by their interest… Thus, we saw ETFs that were longer when rates were very low, and rather shorter in the past few years of higher rates… Too bad for investors, who would have had better returns with the opposite positioning…

It should be noted that these four ETF biases are precisely the areas in which an active bond manager can, without any artifice or inordinate complexity, and probably more easily than an equity manager, make a significant difference to market bond indices: choice of the most profitable issuers rather than the most indebted, diversification by sector and by issuer, choice of the most opportune maturities from the point of view of yield and potential volatility. The current economic climate, with a changing economic regime, a monetary shift, companies at a crossroads, and a bond market offering a plethora of opportunities, is ideally suited to this kind of active management, following the “zero interest rate decade” and the transition to bond carry in 2023. We’ll be delighted to tell you all about these topics and their application to our management at our next presentation, on September 12, 2024(Registration here, places are limited).