Last year saw fixed income reach crisis proportions, especially in the face of Liz Truss’ disastrous short-lived premiership. The depth of investor suffering is highlighted by Bloomberg’s global aggregate bond index which bombed by 16% in 2022. This is its worst performance since 1991, putting the other fixed income crises during the past three decades in the shade.
That was just one shock to the investment system last year and should be put into a wider picture of a global correction in bond markets. The good news, however, is that it could be argued the wild-west environment in fixed income has come to an end.
One scenario could see bonds being the big winners in 2023, while the worst-case outcome could see the asset class supporting portfolios during a deep recession – which everyone from the Bank of England to the International Monetary Fund agrees we will have this year, if we have not entered it already.
Another big boost for bonds is the broader macro picture. As global macro trends temper inflation and central banks pause their rate hikes, bonds should, if this proves to be the orthodoxy, be the big winners.
This is particularly true of high-quality bonds, which have historically performed well after central banks stop raising interest rates, even when a recession follows.
This presents a case for re-thinking fixed income, despite the travails of the past few years.
Bonds appeal to Liz Fernando, Nest’s deputy chief investment officer. “Following their dramatic sell-off in 2022, we find bonds more attractive as their prospective returns have improved. We now see developed market sovereign bonds as, selectively, investible,” she adds.
This would be a turning point for the master trust. Like most defined contribution providers, its growth-oriented portfolio is heavily concentrated in equities.
Surging yields
It also appears that the income drought is over. “The lure of fixed income is strong as surging yields mean bonds finally offer income,” says Scott Thiel, chief fixed income strategist at the Blackrock Investment Institute. “Higher yields are a gift to investors who have long been starved of income.”
A point shared by Steven Meier, chief investment officer of the New York City Retirement System. “Yields have backed up nicely. Fixed income is more compelling. It provides that ballast in a portfolio. It will be a better performer for portfolios over the longer term,” he says.
Daniel Loughney, senior portfolio manager for fixed income at Border to Coast Pensions Partnership, says the yield scenario is indeed a big appeal. “Government bond yields are elevated relative to the past decade. With inflation likely having peaked and market participants looking to have fully priced central bank monetary tightening, we do see value in government debt,” he adds.
Loughney cites UK index-linked debt now offering positive real yields. “With breakeven inflation rates down to more sensible levels, any further easing of volatility will provide an attractive opportunity to gain exposure to this asset class,” he says.
Indeed, this is already a big reversal on the aforementioned bad 2022 for fixed income. “The good news is that if you are now looking to invest new money into fixed income, you can now do so at cheaper prices and a higher yield,” says Olivia Buah, senior investment consultant at Lane Clark & Peacock (LCP).
“Investment-grade and high-yield global corporate bonds are offering some of the highest yields in the past decade,” she adds.
Beyond bonds
This potentially presents a deeper case for not just re-thinking bonds, but re-examining allocations to other fixed income assets.
Nest is one institutional investor looking beyond bonds as other parts of the fixed income universe have also become more attractive. “We are looking closely at infrastructure loans and private credit,” Fernando says. “But as always with riskier investments, we need to be selective in our choices. Our priority is long-term investment growth for our more than 11 million members.”
Other parts of the fixed income landscape also appeal to Loughney at Border to Coast. “Credit spreads are also elevated relative to recent history,” he says. “Certain areas of the US credit spectrum offer strong risk-reward, such as securitised credit given their low duration and relationship to short-dated yields which have been pulled higher by the Fed.”
Loughney is also looking towards the developing world. “Emerging market sovereign dollar-denominated debt looks particularly attractive,” he says. “We believe that US yields could be close to having peaked which should serve to weaken the US dollar. Lower US yields and a weaker US dollar would act as a tailwind for the higher yielding areas of emerging market debt.”
What to buy?
At current yields, short-term government debt also looks attractive to Scott Thiel. “Investors will increasingly ask for more compensation to hold long-term government bonds amid high-debt levels, rising supply and higher inflation,” he says.
Expanding on the case for high-grade credit, he adds: “We think it can hold up in a recession, with companies having fortified their balance sheets by refinancing debt at lower yields.”
Investment-grade corporate bonds are offering a yield of more than 5%, which could be a smart choice for investors open to a little credit risk while staying focused on quality. If interest rates decline, as expected this year, then the conditions bode well for stable and attractive bonds as this is the setting they need to flourish.
Morgan Stanley’s fixed-income strategists have gone all out in predicting high single-digit returns this year from a range of issuers. These include German bunds, Italian government bonds, European investment-grade bonds, as well as in treasuries, investment-grade bonds, municipal bonds, mortgage backed securities issued by government sponsored agencies and AAA-rated securities in the US.
That is quite a list for investors to digest, and indicative of the appealing nature of bonds.
The one area it appears that investors should keep a close eye on is quality. Here US high-yield corporate bonds may look enticing, but they may not be worth the risk during a potentially extended default cycle.
Negative correlation
Government bonds have typically been a source of balance in multi-asset portfolios, offsetting weakness in assets such as equities and credit during risk-off episodes. This has made them a cornerstone of the typical mature defined benefit (DB) portfolio, which relies on steady income streams.
Bonds now account for more than 70% of DB portfolios of which more than 60% are invested in government bonds, according to the Pension Protection Fund.
But the negative correlation between bonds and equities was broken during the pandemic. So, when stock market valuations contracted, bonds did not perform better as they typically would have done.
But two key developments could well help the balance – or hedging – properties of bonds improve.
First, historical evidence suggests that normalising inflation is consistent with the correlation between bonds and risk assets turning less positive, and eventually negative.
Second, higher interest rates are pushing bond yields up, which could cushion weaknesses from equities or credit.
This marks a change from the period following the global financial crisis when low yields limited the ability of bonds to buffer declines in risk assets.
All this adds up to an environment where investors have to be slightly nimble to adapt to the changing nature of the fixed income markets and exploit opportunities where they exist.
In this way, Meier reveals that New York City’s public sector pension funds already have a good allocation to fixed income, but this is going to see an adjustment. “We are looking to increase our holdings of private credit. It has performed consistently over the past several years,” he says.
Quietly optimistic
It appears that despite the upbeat outlook, investors, like Liz Fernando at Nest, are not getting carried away. “At Nest, we remain more cautious on the riskier end of fixed income, such as high-yield and emerging market debt.”
Furthermore, investors have to be selective in their fixed income approach, with some assets being more equal than others. “Long-dated bonds face challenges,” Thiel says. Indeed, by locking in long-term commitments at today’s yields, investors may expose themselves to duration risks and miss out if yields rise further. Thiel, therefore, has a preference for short-term bonds and high-grade credit.
In addition, in the sub-investment grade space, typically defined as lending to companies with a credit rating of BB or below, yields have risen by more than investment-grade bonds.
However, LCP’s Olivia Buah points to an indication of a “Covid hangover” evidenced by interest coverage ratios falling, giving companies less money to make their debt payments with and default rates increasing.
“Investors should proceed with caution here,” Buah says. “We believe the best way to access sub-investment grade markets is via a multi-asset credit strategy.”
Data shows that investment-grade issuers have healthy balance sheets and solid fundamentals. “This means they should be able to manage impending economic challenges and repay investors the money they have borrowed,” Buah says.
“We prefer a buy and maintain approach when it comes to investment grade, where an investment manager buys highquality bonds and aims to hold them to maturity,” Buah adds. “This offers a good balance between active and passive management styles, which keeps transaction costs and management fees low.”
Niche benefits
But the newly arrived appeal of fixed income also stretches into some niche areas. “Those who can afford to lock up their money for longer could look to illiquid credit, which range far wider than the more well-known ‘direct lending’ approach,” Buah says.
“Our view is that infrastructure debt offers a number of attractive features, including steady, reliable returns with a low correlation to mainstream asset classes,” she says, adding: “The underlying companies typically operate in a market where there are considerable barriers to new entrants and strong pricing power.”
Deals in this space are often inflation-linked and ‘floating rate’, offering protection against inflation and rising interest rates. There is even the case within a dynamic and selective investment approach to lean towards the growing universe of green, social and sustainable bonds.
“This is only suitable for long-term investors,” Buah says. “If you’re happy to be tied up in bonds for upwards of 10 years, it’s worth considering.”
Another option for investors looking for higher returns is opportunistic credit. Specialist managers can step in when a company is in a stressed situation, but they believe the company will recover – often with the managers’ guidance and expertise.
Typically, the debt is purchased at a significant discount, with large upside potential. With a potential recession looming in multiple markets globally, this could present more opportunities for these managers to deploy capital at attractive prices.
However, the natural proviso is that investors should always be mindful that with a high expected return comes a greater level of risk.
Tightening cycle
We are now well into the interest rate tightening cycle, and markets expect UK rates to peak in the first half of this year and to stay elevated throughout 2023. On such an outlook, there is every reason to continue to have a positive view on fixed income.
That is, as long as this outlook holds.
Inflation will also play its part. The futures market for the Fed funds rate is predicting a peak at about 5%, which will be reached in April or May. This appropriately coincides with where core inflation is likely, or expected, to be.
If market expectations prove correct, for inflation to be around 3.5% by the end of the year, then US treasuries, through the 10-year maturity, are yielding more than that. That means their inflation-adjusted, or “real,” yield could turn positive.
Meanwhile, municipal and corporate bonds are providing an extra 1.5% to 2.5% beyond treasury yields.
But despite the positive outlook in fixed income, Fernando fires a warning. “Whether bonds are good value or fair value depends heavily on whether you believe we will return to a post great financial crisis low growth, low inflation world or remain in a higher inflation, higher volatility world.”
Border to Coast’s Loughney offers a positive outlook. “With the more attractive valuations in credit and government bonds it is an opportune time to rebalance into fixed income.”
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