The bond market has experienced quite some fluctuations, especially in the past few months. But interest rate cuts by central banks in Europe could boost bond prices. This could lead to more favourable return outlooks for existing and early-bird bond investors.
Today, we’ll look at what expats in Europe investing in bonds need to know about what lies ahead.
Divergence in Monetary Policies
The economies of Europe and the United States are witnessing a notable divergence, driven by differences in growth and inflation rates between the two regions. In Europe, economic activity has been sluggish, and the disinflation process has been ongoing for several quarters. As a result, the European Central Bank (ECB) and the Bank of England (BoE) are likely to continue cutting interest rates in the near future.
The United States has seen a string of stronger-than-expected growth numbers and re-accelerating inflation reports. This has led bond markets to question the continuation of the disinflationary trends observed in late 2023. This has caused a significant repricing in US government bonds since the start of the year.
Potential Rate Cuts and Their Impact
If the ECB and the BoE proceed with rate cuts, it could materially alter the return outlooks for existing bondholders through more favourable returns, as lower rates generally support rising bond prices.
However, investors should brace for heightened volatility in bond markets in the months ahead as any unexpected changes in monetary policy are likely to impact bond prices.
Positioning Fixed Income Portfolios
In times of fluctuations and inflation, investors should consider diversifying their fixed-interest portfolios to mitigate risk. Current bond yields provide healthy levels of income, which can help absorb future volatility in bond prices.
For example, the Bloomberg Global Aggregate Credit Index is currently yielding close to 5%, meaning interest rate expectations would need to rise by more than 0.75% from current levels before negative returns are expected.
Credit Market Outlook
Global credit markets have been relatively stable compared to government bond markets so far this year. In Europe, credit spreads are wider than in the US, but the gap is narrowing. This reflects investor optimism and recent ratings upgrades of several issuers from high-yield to investment-grade.
Despite the heightened fluctuations, credit spreads are tightening and trading below their historical averages, which has boosted returns for credit investors. As long as credit spreads remain within a range and are supported by a stable macroeconomic backdrop, corporate bonds can still deliver excess returns relative to government bonds.
Currency Risk Management
Given the potential volatility in currency markets, especially with the expected monetary policy divergence, it is advisable for investors to hedge their currency exposure in fixed income portfolios. Hedging can significantly reduce the volatility associated with currency fluctuations, allowing fixed income investments to perform more predictably.