Fed hikes remain in play, but higher yields are creating opportunities

Eric Souders

Persistent inflation, elevated real yields and heavy bond issuance from the technology sector are creating a more challenging backdrop for risk assets, but the repricing in bond markets is also producing attractive opportunities for fixed-income investors, according to Payden & Rygel portfolio manager Eric Souders.

Souders said 10-year US real yields around 2.5 per cent were already approaching levels that had historically proved difficult for risk assets, particularly when combined with a stronger US dollar and higher oil prices.

“Higher bond yields, especially higher real yields, a stronger dollar and higher oil prices are all leading to slightly tighter financial conditions. That can put pressure on risk assets,” said Souders.

However, he said the rise in yields was not necessarily signalling an imminent deterioration in the US economy. In some respects, it reflected the opposite.

US earnings grew by approximately 30 per cent year-on-year in the latest quarter after excluding unusually large investment gains, while nominal economic growth was running at around 6.5 per cent.

Souders said the strength of the economy, combined with persistent inflation and uncertainty around fiscal deficits, was helping drive yields higher.

“Growth is not the problem. In fact, growth is probably too strong given the prevailing level of inflation,” he said.

“The Federal Reserve’s reaction function is becoming increasingly clear, with inflation remaining its primary concern. The market should not rule out further rate hikes.

“Our base case is that the Fed hikes within the next meeting or two, with two hikes likely by early 2027,” he said.

With close to two hikes already reflected in market pricing by early 2027, however, Souders said the risk-reward in front-end US rates had become more attractive.

“We have become somewhat more constructive on the front end of the US yield curve. Current pricing is broadly consistent with our expectation for the Fed, while all-in yields are attractive. Investors are being well compensated while they wait to see whether those hikes are ultimately delivered,” he said.

Despite the more challenging backdrop for risk assets, Souders remains positive on credit and believes fixed income continues to offer compelling opportunities. Strong household and corporate balance sheets, relatively low leverage and continued investment in AI all remain supportive.

“We like credit. Investors don’t need to take a lot of risk to generate an attractive yield. You can remain exposed to higher quality assets and build a portfolio that’s yielding roughly 6-7 per cent, which matters when the starting yield in fixed income has historically been the biggest driver of returns.”

He cautioned, however, that investors need to remain selective.

“Software is one area of particular concern, with AI challenging existing business models and making long-term revenues, margins and valuations more difficult to assess. We are comfortable sitting that one out.”

The scale of investment required to build AI infrastructure is also expected to remain an important factor for bond markets.

Souders said the major technology companies had already had a meaningful impact on bond supply and yields.

“The hyperscalers have generated a tremendous amount of bond supply this year, particularly at longer maturities, putting additional pressure on yields. We expect that supply to continue for the remainder of this year and into next year,” he said.

Financing to date has come primarily through traditional fixed-rate investment-grade corporate bonds, but Souders expects the mix to broaden over time to include securitised transactions and bank loans. Regardless of financing structure, he expects the capital requirements associated with AI infrastructure investment to remain substantial through 2027 and into 2028.

“Against an already heavy backdrop of US Treasury issuance, an outsized amount of longer-dated, fixed-rate corporate supply would leave investors with considerably more duration to absorb. All else equal, that should put further upward pressure on longer-term US bond yields,” he said.