Bonds back in contention

Fixed income may again be offering portfolio diversification and risk reduction potential, but there is a new challenge for advisers in communicating bond benefits to clients.

The traditional role of bonds – offering diversification, reducing volatility and portfolio risk – has been dramatically challenged in recent times.

Since December 2019, aggregate fixed income lost 10.9 per cent, according to Bloomberg. In 2022, it posted its worst returns in almost 50 years, as central banks raised interest rates to combat inflation, surging from the Covid-19 pandemic and war in Ukraine. Global equities gained 55.1 per cent over the same five year period. This represents a 10.4 per cent per annum gain for equities and a 2.6 per cent annual loss for bonds.

Since major central banks ended their rate hiking cycle last year, investors have endeavoured to lock in historically high yields and position themselves to make capital gains when rates start to fall.

Yet with the Fed expected to resume cutting later this year, with markets expecting one or two rate reductions versus six to seven at the beginning of 2024, attractive cash rates make the hurdle for investing higher. Persuading clients to move from cash to bonds, before yields decrease, is one of the biggest challenges private bank investment bosses face today.

“Cash is very attractive for clients with short time horizons, as it still pays high returns in absolute terms, which we haven’t seen for a long time,” says Nicolas Bickel, group head of investment, private banking at Edmond de Rothschild.

But this is a “narrow-minded short-term view”, as cash rates will decrease. “Clients with a long-term view need to think about switching money to fixed income right now, to secure high yields for longer, even if credit is very expensive,” he adds.

The fixed income market, a better predictor than equities of future economic cycles, does not price in any recession today, either in the US or Europe. “Spreads are really tight, meaning investors are satisfied with a narrow premium to compensate for risk of higher default rates,” says Mr Bickel

The Fed will do “whatever it takes” to reduce inflation to its 2 to 2.5 per cent target and decrease interest rates. “Rather than the timing of the next Fed cut, what is important is the direction and landing. We are talking about lower for sure, not higher for longer.”

Earlier this year, half of private bank chief investment officers (CIOs) from PWM’s ninth annual Global Asset Tracker survey recommended clients should overweight bonds, especially high quality fixed income, to protect portfolios in case of recession. The study surveyed CIOs and heads of investments at 54 private banks, managing $22tn in combined client assets.

More than two-thirds believed fixed income allocations would increase in 2024, expecting bonds to be better portfolio diversifiers than in the past two years of high inflation. “We have a ‘most preferred’ view on fixed income, but most specifically high quality fixed income,” confirms Solita Marcelli, CIO Americas, UBS Global Wealth Management. “People have heard enough talk about rate cuts, now they want to see it happening, so they can make money from fixed income.”

UBS expects near-term rates for 10-year Treasuries to range from 4 to 4.5 per cent, falling to 3.85 per cent by year-end. Investors buying a standard 10-year Treasury today would get 11 per cent total return over the rest of the year, because of price appreciation.

Some BBB commercial backed securities (CMBs) have returned double digits during 2024. Ms Marcelli favours Triple A or higher quality CMBs, where spreads are not as tight in housing and commercial mortgages as in other investment grade. Headline risk, related to last year’s collapse of regional banks exposed to commercial real estate, kept investors out of the market, but today this risk is priced in. Opportunities also abound for taxable US investors in high-quality, long-dated US municipal bonds, offering up to 8 per cent “if you live in high tax states like New York”, she explains.

Portfolio diversifiers

Buying short-dated bonds – one to five year duration in the US and one to three in Europe – has been one of JP Morgan Private Bank’s “key investment recommendations this year, and one clients have acted on to a significant extent”, says Grace Peters, the bank’s global head of investment strategy. An inverted yield curve for much of the past 12 to 18 months left interest rates on short-term bonds higher than long-term securities.

Where clients are not following advisers’ recommendations is duration. “With the US delivering above trend growth and Europe and China bottoming out, providing cyclical impulse to the global economy, everybody is less worried about recession, and more worried about stronger growth and potential re-emergence of inflation,” says Ms Peters. “In this environment, duration is deemed less attractive by clients, worried more about upside inflation risks than downside growth risks.”

JP Morgan assigns equal probabilities – 20 per cent – to recession and upside inflation risks, with the core scenario of continued expansion or soft landing. Clients are therefore encouraged to be “neutral duration” to account for both tail risks. In dollar-based discretionary portfolios, duration has been extended from underweight to neutral, at six and a half to seven years.

Fixed income remains a good diversifier for downside risks, says Ms Peters. But if there are also upside risks to inflation, investors should increase sources of diversification to account for both scenarios, investing in alternatives, including infrastructure assets, offering protection against resurgent inflation.

JP Morgan predicts inflation will recede gradually, not meeting the Fed’s 2 per cent target until 2026. While 10-year Treasury yield is predicted to decrease to 4.5 per cent at the end of 2024, and 4.45 per cent by end 2025, it will not return to the 2/2.5 number seen for much of the post global financial crisis period, believes Ms Peters.

Megatrends in motion

Megatrends including ageing demographics, decarbonisation and deglobalisation will also prove inflationary, keeping interest rates above pre-financial crisis days.

While ageing demographics often signal secular stagnation, an alternative view suggests a greater percentage of older people means more consumers and fewer producers, creating upward inflation, explains Sonal Desai, CIO of Franklin Templeton Fixed Income. Decarbonisation may reduce longer-term prices, but there is an “extended transition phase” during which it adds pricing pressure, as does deglobalisation or ‘friendshoring’.

After the short cutting cycle the Fed will embark on later this year, the world will head towards ‘renormalisation’ of the yield curve, believes Ms Desai, allowing fixed income to provide a “ballast for the equity part” of portfolios.

“Fixed income will deliver because of yield compression, but most return will come from ‘carry’, from the income component. For the first time in 15 years, fixed income will be doing what it says on a can, providing income,” she says, predicting long yields will settle in the “5 per cent plus” range.

With the US economy strengthening, Ms Desai favours European ahead of US duration, as the European Central Bank, which recently cut interest rates for the first time in five years, enjoys more opportunities to make cuts to support the economy.

Emerging opportunities

While high quality investment grade appears attractive, more risky segments like high yield and emerging market (EM) fixed income also offer opportunities, although selection is paramount.

Investors should not buy the index, “as spreads on high yield indices are too compressed to offer sufficient cushion in event of recession,” warns Ms Desai. With dollar strength likely to continue for “a little longer”, she prefers hard currency to local currency emerging markets, emphasising bottom-up selection.

Higher yielding EMs, including frontier markets, offer “very good” value to specialised investors. “EM has done well, but it has a much room to catch up with areas such as high yield. We still think there is value in emerging markets,” says Ms Desai.

Within fixed income, EM high yield is one of 2024’s better performers, says Bank of Singapore’s CIO Jean Chia. The Asian bank – boasting a specific research team covering EM fixed income – went overweight EM high yield earlier this year, believing global recession risk had reduced, with a “sufficient buffer in terms of valuations to generate returns”.

By scrutinising balance sheets, business models and leverage of EM corporates, the bank aims to understand “whether spreads are sufficient to compensate us for higher risk we take going down the derating ladder”, says Ms Chia, explaining the importance of diversification across regions and companies. “EM high yield provides value, balancing the duration call in investment grade, both in developed and emerging markets.”

Investment grade bonds have greater rate sensitivity, providing a buffer in case recession risks increase, explains Ms Chia. Private credit is also a yield instrument drawing interest from clients, with multiple return drivers building portfolio resilience.

“Some loan structures may be different from traditional fixed income instruments, or less sensitive to short term interest rate movements, so you don't get the volatility, for example, of duration risk at any point in time,” she says. While it could be argued this also applies to public markets, if the coupon continues to be paid, prevailing short-term volatility becomes “too distracting for long-term investors”.

Future risks

While generally considered as a defensive asset class, fixed income faces several risks. “The biggest risk for bond markets is that inflation proves to be stickier, or rather doesn't come down at the pace that everyone's expecting,” says Adam Whiteley, head of global credit at Insight Investment. That would likely lead markets to price central banks maintaining the current level of restrictive policy for longer, he says. “This is now our central case We expect to see inflation coming back down to central bank targets, helped out by a labour market which is beginning to ease up a little bit.”

While recent strong jobs data in the US continue to defy predictions of a slowdown, the deflationary or disinflation process is bound to see setbacks, says UBS’s Ms Marcelli, pointing to reassuring signs such as wage growth slowing. “We always knew the move down from 9 per cent inflation to 3.5 per cent was the easiest part. And this last mile on, from 3.5 to 2 per cent was going to be harder.”

Key risks to monitor that could cause real yields to spike again include a “too good” US growth, which would lead the Fed to raise rates to avoid overheating.

In a world characterised by upside inflation risks and huge government debt, investors’ concerns about the ability of the Fed to be able to readily implement measures to support the economy and prevent substantial market declines, as it has done in the past decade, also need to be monitored. These worries translate in the bond market through higher term premia, or a greater compensation for locking up money with the US government for the long term.

“A scenario where economy is slowing and rates are not coming down because there’s all these worries about government debt would be a very difficult place to be,” says Ms Marcelli.

Such concerns have led high profile industry figures to question the future of bonds.

Bill Gross, Pimco’s co-founder, recently declared the death of so-called bond total return strategy, which he pioneered more than 40 years ago. The bond market will continue in a protracted bear market, marked by higher interest rates due to higher than expected inflation and massive debt issuance to fund continued deficits, he argues.

“Bonds are not dead. The poor performance we’ve witnessed thus far is, in our view, an outcome of yields resetting higher in both real and nominal terms after a full cycle of being at unusually low levels,” believes Manpreet Gill, CIO, Africa, Middle East and Europe at Standard Chartered.

The outlook for bonds has now improved considerably, as the starting yield is usually the dominant driver of future returns, he adds.

Clients should have an overweight exposure to bonds relative to cash, where reinvestment risk – the risk of reinvesting maturing cash deposits at much lower yields in coming years – is high.

Relative to equities, it is a harder case to make for now, says Mr Gill, as equities usually outperform bonds in most non-recessionary years, although they are much more volatile. Standard Chartered today has an overweight position to equities, neutral to bonds and alternatives, and underweight in cash.

While higher yields put a natural cap on how far the rerating of bonds can proceed, George Lagarias, chief economist at consulting firm Mazars, does not expect a “quick fixed income rebound”, but possibly a dragged-out one.

“It will take years for those who were fully exposed to the 2022 crash to recuperate their losses by being in a simple fixed income portfolio,” he says.