Mechanisms to increase the yield of government bonds

This week, risk-losing sentiment has picked up again, and the reason for that remains…rising government bond yields!

The mechanism behind what happens is that when government bond yields rise, investors turn to capital preservation, reducing exposure to the investments most affected by rising government bond yields. In the lending industry, “investment grade” corporate bonds, that is, bonds with a low coupon and long maturities, are the first to be sold. As the supply of junk loans for sale grows, buyers demand higher risk premiums to own them, and spreads widen. Credit rating agencies consider investment grade loans to have lower credit risk.

So the mechanics make it impossible for investment grade spreads to widen without the most speculative part of the universe, the high returns, following them. Rising government bond yields could also make high-yielding investors more worried about extension risk — the willingness and ability of companies to call their bonds on the first scheduled date — given that these companies’ ability to raise capital at below-current yields. coupon on their bonds becomes impossible. Cyclic sectors and hybrid structures are not popular in this environment. Meanwhile, the strategists are oppressing the animals by explaining that inflation remains high, which is bad news for corporate profits, and that companies operating on low margins should be sold. They argue that the best course of action for central banks is to aggressively raise interest rates to slow the economy and increase unemployment—the same strategists then sell consumer cyclical stocks.

There is a simple solution to stop the risk dynamic: government bond yields must stop rising. This week we had two key events that were not part of the solution. First, at the ECB meeting, President Lagarde announced that the Asset Purchase Program (APP) would end in July and that the ECB would raise interest rates by 25 basis points in July (for the first time in ten years). It is best to keep raising interest rates at a rate of 25 basis points per month, so without a meeting in August, there is a possibility that interest rates will rise by 50 basis points in September. According to the ECB’s updated economic forecasts, growth has been revised down and inflation has been revised up. Inflation is now expected to remain above the ECB’s 2% target over the entire forecast horizon, reaching 2.1% in 2024. This forecast raised concerns among investors about a prolonged bull cycle. Then we had the US Consumer Price Index (CPI) data. Headline inflation accelerated, with both headline and core inflation exceeding consensus (YoY CPI 8.6% vs. 8.3% consensus; Core CPI 6.0% vs. 5.9% consensus). The market reaction was to expect another 25 basis points to rise over the next 12 months. So withdrawal reactions continue. Despite all this inflation, American households are fortunately on a healthy balance sheet with a $2.4 billion savings surplus. We believe these deferred savings will continue to support growth; we still don’t think the United States will enter recession in 2022.

2022.06.15.Excessive savings
Inflation is rising, but the US household savings surplus is $2.4 trillion.
Source: Federal Reserve, Department of Commerce, Goldman Sachs Global Investment Survey, May 30, 2022.

This material should not be construed as a forecast, study or investment advice, nor does it constitute a recommendation, offer or solicitation to buy or sell securities or to follow any investment strategy. The views expressed by Muzinich & Co. are current as of March 2022 and are subject to change without notice.