Bonds bounce back


12 Dec 2023

After a torrid few years, there are reasons to be upbeat about bonds again, finds Andrew Holt.

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After a torrid few years, there are reasons to be upbeat about bonds again, finds Andrew Holt.

Bonds are back. That’s the message of the latest portfolio institutional roundtable. But is this valid? It is a question worth pondering, especially given that inflation is still relatively high.

Plus interest rates have stayed higher for longer. And although the threat of a recession has receded, it has far from being removed entirely.

This year has seen a small segment of stocks driving the market, the so called magnificent seven tech stocks – Apple, Amazon, Alphabet, Nvidia, Meta, Microsoft and Tesla – being the standout movers.

But it is worth noting that in bond investing there are many more issuers than in the equity market. And the high yields on offer should appeal to investors.

“If investors want to get two-year bonds and lock in these high yields for a shorter amount of time or extend out to 10- or 30-year bonds,” said Natalie Trevithick, director and head of investment grade corporates at Payden & Rygel. “And even though their yields may be a little lower there than they are in the front end, given the inverted yield curve, you are locking in these higher yields for longer,” she added.

Longer maturities

Although a key point within this is when should investors start to lengthen maturities in anticipation that the rate picture is changing? “Now is the time to do it, because we have seen the curve start to un-invert,” Trevithick added.

She noted that there is only about an 18 basis points differential between two-year and 10-year treasuries: just 18 basis points lower than that, and we have an upward sloping treasury curve from 10s to 30s.

“So, we are seeing more demand for 10- and 30-year corporate bonds because people want to lock in these higher yields for longer periods,” Trevithick added.

Hal Cook, senior investment analyst at Hargreaves Lansdown, agreed, but sees a shorter timeframe as appealing. “On a five-year horizon, bonds are attractive,” he said.

But on the flip side, Trevithick is seeing corporations wanting to issue more short-term debt: two, three and five-years because, even though they may be paying higher interest payments today, they do not want to lock in those rates for longer.

“So, there’s a little bit of a bifurcation between what investors want to buy and what corporations want to issue into the market,” she said.

Regional attraction

Is there a regional basis for more attractive bonds? “We do see value globally on a name specific basis, but our preferred domicile right now is the US given our stronger outlook there,” Trevithick added.

In addition, Philip Saunders, director at the Investment Institute, said for the first time since the 2008 financial crisis, bond valuations in the US and Europe are competitive relative to other asset classes – provided inflation rates remain moderate, which he expects.

“Developed market bonds offer a tactical opportunity which will not signal a return to the prior ‘post-financial crisis’ inflation and interest-rate regime,” he added.

When it comes to emerging market debt, the policies of the developed world such as quantitative easing and zero rates were never an option. Consequently, their response to Covid was more fiscally conservative than developed economies. They are benefiting from that now, Saunders said. “To generalise, the emerging markets debt story in 2023 is as follows: positive fundamentals, falling inflation and high real interest rates have resulted in relative resilience in the face of the duration bear market and a strong US dollar.”

Therefore, new sources of industrial demand play into the hands of many emerging market countries, which are in a fundamentally better shape than in previous times of stress in developed markets.

Declining inflation will allow interest rates to fall in many emerging economies, providing opportunities in duration, Saunders added.

This dynamic would be boosted by an inflection in US interest rates, which would reduce the risk to emerging market currencies as they progress on their easing cycles. “We see Latin American economies, such as Brazil and Colombia, benefitting most, given their high real rates, positive inflation dynamics and solid external balances,” Saunders said.

He also noted that he sees “interesting potential” in specialist segments such as senior and subordinated bank debt, as well as structured credit. “This is where we believe investors are overcompensated for credit risk compared to traditional high- yield and investment-grade corporate bonds,” he said.

Despite the uncertainty of the macro-economic picture, Hal Cook said even if we do see a recessionary environment it will impact equities more substantially and negatively.

“A recession feels like it would be worse for equities as opposed to bonds, particularly if it makes central banks cut rates sooner than expected. At least with bonds you’re being rewarded in with yield while you wait,” he said.

The conclusion can only mean one thing: bonds are not just back but are a good investment opportunity.


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