The curve is not flat

December 3, 2024

If you have any feedback on this article or are interested in subscribing to our content, please contact us at opinions@muzinich.com or fill out the form on the right hand side of this page.

--------

In his latest column on the key developments, themes and opportunities in credit markets, Ian Horn examines what the normalisation of yield curves means for investors in the European investment-grade market.

After an extended period of flat – and even inverted – European corporate yield curves, we are finally seeing signs of normalisation. This is a healthy development and signals the diminishing distortion in bond markets caused by monetary policy intervention.

In ‘normal’ credit markets, longer-dated bonds offer investors compensation over shorter-dated ones through higher yields for the additional risks inherent in those bonds. This pickup typically comes from higher underlying government bond yields and credit spreads.

Since early 2023, markets have been anything but normal, with a yield premium in shorter-dated bonds. This has kept many investors comfortable in lower-risk credit and fixed income, including money market instruments, where European holdings are at record levels.¹ Investors have been able to shelter from volatility in interest rates, whilst earning a decent nominal yield at the same time.

Normal service resumes

Since the middle of 2024, however, yield curves have begun to normalise.

Front-end government bond yields have fallen by more than long-end bond yields as the European Central Bank has embarked on a rate-cutting cycle. As a result, the coveted ‘2s-10s’ yield differential (the difference between German 2-year and 10-year government bond yields) turned positive in September for the first time since November 2022.

Meanwhile, spread curves have also been normalising. At the start of the year, the 10+ year part of the market offered less than 5 basis points (bps) of spread premium over the 1–3-year part of the market. This has since widened to more than 30bps at the end of October.²

Figure 1 highlights the yield premium available in different parts of European investment-grade credit compared to the 1–3-year segment - in other words, how much more yield investors get to extend duration. It shows that wider credit spreads and higher government bond yields are again combining to offer a yield premium to those willing to extend duration in credit.

Short and sweet

Even within short-duration strategies, there has a been a strong argument recently to maintain a shorter duration bias given the limited yield pick-up from extending duration. During much of 2023 and early 2024, the highest yields in European investment grade were available in the 1–3-year part of the market. This is one reason we have favoured a short-duration bias, even within the constraints of our short-duration strategies.

We believe there remain strong arguments for more conservative investors to favour short-dated credit, particularly those coming out of cash and looking to enhance yields. And there are also structural benefits of short-dated credit that will be evident through the cycle, including less sensitivity to interest rates and greater visibility over repayment.

However, the return of yield premia could signal an opportunity for investors to start to extend duration on a gradual basis as markets continue to normalise. Upward sloping yield curves offer higher yields for those willing to extend duration, and also the possibility to benefit from positive ‘roll-down’ – the price appreciation seen in a bond due to its falling yield as it ‘rolls down’ the yield curve towards maturity. This is a source of return that is not available when yield curves are flat or inverted.

Although the normalisation of yield and spread curves is still at an early stage, it is important to recognise the recent period of distortion in credit markets looks to be ending.

Consequently, the opportunity set within credit is changing. Low-risk opportunities created by higher interest rates are starting to fade as policy rates fall – for example, in cash deposits, short-dated government bonds and money market instruments – whilst in our view, incentives to move into credit and along the yield curve are gradually becoming more compelling.

References

1. The Institutional Money Market Funds Association, ‘IMMFA Assets Under Management,’ as of November 8, 2024
2. ICE BofA Platform, as of October 31, 2024

 

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. References to specific companies is for illustrative purposes only and does not reflect the holdings of any specific past or current portfolio or account. The opinions expressed by Muzinich & Co. are as of December 2024, and may change without notice.

--------

Index descriptions

ER01 - ICE BofA  1-3 Year Euro Corporate Index is a subset of ICE BofA  Euro Corporate Index (ER00) including all securities with a remaining term to maturity less than 3 years.

ER02 - ICE BofA  3-5 Year Euro Corporate Index is a subset of ICE BofA  Euro Corporate Index (ER00) including all securities with a remaining term to final maturity greater than or equal to 3 years and less than 5 years.

ER03 - ICE BofA 5-7 Year Euro Corporate Index is a subset of ICE BofA Euro Corporate Index including all securities with a remaining term to final maturity greater than or equal to 5 years and less than 7 years.

ER04 - ICE BofA 7-10 Year Euro Corporate Index is a subset of ICE BofA Euro Corporate Index including all securities with a remaining term to final maturity greater than or equal to 7 years and less than 10 years.

ER09 - ICE BofA 10+ Year Euro Corporate Index is a subset of ICE BofA Euro Corporate Index including all securities with a remaining term to final maturity greater than or equal to 10 years.

Important information

Muzinich and/or Muzinich & Co. referenced herein is defined as Muzinich & Co., Inc. and its affiliates. Muzinich views and opinions.  This material has been produced for information purposes only and as such the views contained herein are not to be taken as investment advice. Opinions are as of date of publication and are subject to change without reference or notification to you. Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy. The value of investments and the income from them may fall as well as rise and is not guaranteed and investors may not get back the full amount invested. Rates of exchange may cause the value of investments to rise or fall.

Any research in this document has been obtained and may have been acted on by Muzinich for its own purpose. The results of such research are being made available for information purposes and no assurances are made as to their accuracy. Opinions and statements of financial market trends that are based on market conditions constitute our judgment and this judgment may prove to be wrong. The views and opinions expressed should not be construed as an offer to buy or sell or invitation to engage in any investment activity, they are for information purposes only.

This discussion material contains forward-looking statements, which give current expectations of future activities and future performance. Any or all forward-looking statements in this material may turn out to be incorrect. They can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. Although the assumptions underlying the forward-looking statements contained herein are believed to be reasonable, any of the assumptions could be inaccurate and, therefore, there can be no assurances that the forward-looking statements included in this discussion material will   prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation that the objectives and plans discussed herein will be achieved. Further, no person undertakes any obligation to revise such forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

United States: This material is for Institutional Investor use only – not for retail distribution. Muzinich & Co., Inc. is a registered investment adviser with the Securities and Exchange Commission (SEC). Muzinich & Co., Inc.’s being a Registered Investment Adviser with the SEC in no way shall imply a certain level of skill or training or any authorization or approval by the SEC.

Issued in the European Union by Muzinich & Co. (Ireland) Limited, which is authorized and regulated by the Central Bank of Ireland. Registered in Ireland, Company Registration No. 307511. Registered address: 32 Molesworth Street, Dublin 2, D02 Y512, Ireland. Issued in Switzerland by Muzinich & Co. (Switzerland) AG. Registered in Switzerland No. CHE-389.422.108. Registered address: Tödistrasse 5, 8002 Zurich, Switzerland. Issued in Singapore and Hong Kong by Muzinich & Co. (Singapore) Pte. Limited, which is licensed and regulated by the Monetary Authority of Singapore. Registered in Singapore No. 201624477K. Registered address: 6 Battery Road, #26-05, Singapore, 049909. Issued in all other jurisdictions (excluding the U.S.) by Muzinich & Co. Limited. which is authorized and regulated by the Financial Conduct Authority. Registered in England and Wales No. 3852444. Registered address: 8 Hanover Street, London W1S 1YQ, United Kingdom. 2024-11-29-15008