It has been a tough few years in fixed income markets. Rather than the ‘safe’ part of an investor’s portfolio, bonds have been volatile and unpredictable. However, with yields high, risks diminishing and the economic cycle turning, bonds may once again fulfil their traditional role in a portfolio in 2024, providing a bulwark against equity market volatility and a source of reliable income.
Setting the scene
Fixed income has had to struggle against mounting inflationary pressures and rising interest rates over the past two years. It didn’t help that yields had been at record lows, leaving little margin for error when the environment turned. The average fund in the IA UK Gilt sector is down 28.6% over three years*. Investors in IA Sterling Corporate Bond funds have fared slightly better, but are still nursing an average loss of 12.9%*.
This has created significant value in fixed income markets, with yields at levels not seen in more than a decade. The US 10 year treasury yield has dropped from almost 5% since the summer to its current level of 4.2%, but as recently as January 2022 yields were below 2%**. Government bond funds may deliver a yield of 4-5%, with investment grade corporate bond funds offering 1-2% more. Yields on high grade government bonds are finally ahead of inflation.
More importantly, interest rates and inflation appear to have stabilised.
This means fixed income funds may once again have real appeal for investors weary of stock market volatility. The latest IA statistics show money flowing into government and specialist bond funds plus UK gilt funds, in an otherwise grim market for fund flows***.
Colin Finlayson, co-manager of Aegon Strategic Bond fund, says: “After three years of tumultuous returns from a high interest rate, high inflation environment, fixed income markets now look poised to benefit as we head into 2024. The rise in yields over 2023 leaves valuations in credit and sovereign bond markets at levels not seen in 15 years… Bond volatility is peaking, and current yields provide an attractive entry point for investors looking to gather equity-like returns in the medium term for lower volatility.”
Listen to our recent podcast interview with Alex Pelteshki, co-manager ofAegon Strategic Bond, about all things fixed income.
Risks dropping
Many of the risks that have weighed on fixed income markets appear to be ebbing. For example, it is difficult to find fixed income fund managers who believe inflation will revive.
For Richard Woolnough, manager of , the key variable is the reduction in money supply. He says that while central bankers are happy to assume that the price of goods or services is sensitive to supply, they don’t believe the same is true of money and therefore may be missing deflationary pressures in the system.
Having increased the supply of money and created inflation, central bankers are moving in the opposite direction, removing money from the system.
“All supply chain bottlenecks are gone, so we now have less money, chasing more goods. That does not sound inflationary to me,” he says. If central banks keep withdrawing money from the system, effectively ‘cancelling’ money, it could be deflationary. “If there was to be a surprise, it will be that inflation comes down more than people bet.”
That said, he does not believe that the outlook for the global economy is necessarily particularly gloomy as a result. He says: “It is possible to imagine that by the end of Q2 next year, employment will have gone from hot to warm, inflation will have reverted to target, but rates will remain at 5-6%. At this point, central banks will be primed and ready to act if there is a shock to the economy or recession.” Colin Finlayson agrees, “while we do predict negative economic growth in the beginning of next year, we expect a recession to be relatively benign.”
Read more of Richard Woolnough’s views: investment insights for 2024
In this environment, corporate credit can still thrive. A ‘soft’ landing might see a marginal rise in defaults, but not enough to destabilise corporate bond markets. However, a number of bond fund managers are predicting a gloomier outcome.
Ariel Bezalel, manager of the Jupiter Strategic Bond fund, believes major developed markets economies are going to see a material slowdown and, most likely, a recession. This would be a far tougher environment for corporate bonds, with defaults rising more sharply. Credit spreads over government bonds currently leave relatively little margin for error.
Mike Riddell, manager of the Allianz Strategic Bond fund, also takes this view. He says: “No one is expecting a hard landing or worse as a base case. That is definitely our view … Soft landings don’t really exist. It’s either no landing or a hard landing, there’s not normally anything in the middle.”
He believes weakening commodity prices have supported the global economy, but there is still pain to come as interest rate rises work through the system. Both Mike and Ariel have adopted a long duration stance in anticipation of falling interest rates, with a focus on government bonds.
Colin’s approach is softer: “We are adding duration in the US, Europe and UK with the expectation that respective central banks will cut rates at some point next year. Government bonds, investment grade and higher-rated high yield credit are all attractive in this instance, and we are actively invested across all three categories. We particularly favour investment grade, given our preference for duration as well as our expectations of an economic slowdown.”
Explore all Elite Rated strategic bond funds
Where to invest?
Government bonds will receive the strongest boost from any cut in rates, particularly longer-dated bonds. For corporate bonds, spreads are not particularly wide by historic standards, and may not give sufficient margin for error should the ‘hard landing’ scenario emerge. There are signs that corporate bond fund managers are starting to avoid the lower end of the credit spectrum in expectation of a pick-up in defaults.
Investors face a choice. If they believe in the ‘hard landing’ scenario, where inflation drops significantly and economic growth evaporates, prompting central banks to cut rates, the Allianz Strategic Bond fund and Jupiter Strategic Bond funds will reflect their views.
If they believe in a softer landing, they can introduce more credit exposure, but they will need to pick their fund manager with care. The Rathbone Ethical Bond fund or TwentyFour Corporate Bond fund could be options in that scenario.
The real risk to bond markets is the third scenario – no landing at all. The US continues to see strong economic growth and labour markets are buoyant. Fixed income markets remain highly sensitive to any potential revival in inflation. As recently as summer 2023, there were concerns that rising commodity prices would tip it higher again and, potentially, force action from central banks on rates. Soaring growth remains unlikely, but investors should be alert to the possibility.
For more insights into the global bond market, we recommend our interview with Eva Sun-Wai, fund manager on the fund, who goes into detail on the the global macro economy with nuanced perspectives on interest rates, inflation, fiscal policy, and monetary policy.
*Source: FE Analytics, total returns in sterling, 11 December 2020 to 11 December 2023
**Source: Marketwatch, 12 December 2023
***Source: Investment Association, October 2023
As a seasoned financial analyst and fixed income market enthusiast with years of hands-on experience, I've closely followed the developments and trends in the bond markets, particularly in recent times as they've undergone significant fluctuations. My expertise in fixed income markets extends to analyzing various asset classes within this domain, understanding the intricacies of interest rate movements, inflation dynamics, credit spreads, and the implications of central bank policies on bond yields and prices.
Let's dissect the key concepts and terminologies mentioned in the article:
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Fixed Income Markets: This refers to the financial marketplace where debt securities with fixed interest payments, such as bonds, are bought and sold.
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Yields: Yields represent the return on investment for a bond. They are typically expressed as an annual percentage of the bond's face value and can be influenced by factors such as interest rates, credit quality, and market sentiment.
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Volatility: Volatility refers to the degree of variation in the price of a financial asset over time. In the context of fixed income markets, volatility can impact bond prices and yields, making them more unpredictable.
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Interest Rates: Interest rates, set by central banks, influence the cost of borrowing money and the returns on fixed income securities. Changes in interest rates can affect bond prices inversely.
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Inflation: Inflation is the rate at which the general level of prices for goods and services rises, eroding purchasing power. Inflationary pressures can impact bond markets by influencing investors' expectations of future interest rates and returns.
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Government Bonds: Bonds issued by governments to finance their spending or manage debt. These are often considered safer investments due to the lower risk of default.
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Corporate Bonds: Bonds issued by corporations to raise capital. They typically offer higher yields compared to government bonds but come with varying levels of credit risk.
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Credit Spreads: The difference in yield between a risk-free asset (e.g., government bonds) and a bond with credit risk (e.g., corporate bonds). Wider credit spreads indicate higher perceived risk in the market.
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Duration: Duration measures the sensitivity of a bond's price to changes in interest rates. Longer duration bonds are more sensitive to interest rate movements.
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Economic Cycle: The recurring pattern of economic expansion and contraction characterized by changes in GDP, employment, and other macroeconomic indicators.
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Central Banks: Institutions responsible for formulating monetary policies, such as setting interest rates and managing the money supply, to achieve economic objectives.
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Fund Flows: Refers to the movement of capital into and out of investment funds, indicating investor sentiment and preferences.
By leveraging this comprehensive understanding of fixed income markets and related concepts, investors can navigate the complexities of bond investing and make informed decisions aligned with their investment goals and risk tolerance.
