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The fixed income asset class has been shunned by global investors for many years – and who can blame them? Bond yields have traded at low or even negative levels up until recently. At a staggering US$127 trillion, it is a large asset class to overlook, exceeding the global equity market in size.
How did we get here?
The comeback has not been all plain sailing. Fixed income investors have had to endure many years of unattractive valuations, followed by a great deal of pain in 2022. Understandably, investors searched for more attractive alternatives. 2022 was a year that will be remembered for being one of the worst on record for fixed-income returns. The asset class also reached an important milestone that year – it brought about a Great Reset. A new chapter has now begun.
In the midst of chaos, there is also opportunity
A combination of high inflation and aggressive central bank interest rate hikes has caused bond yields to aggressively reprice higher to levels that have not prevailed in over ten years in some regions. Bond yields now offer a more attractive income stream, and with it, insulation from further losses in a scenario where yields move higher. In the US, the yield on the 10-year US Treasury bond started 2022 at 1.5% and reached a peak close to 4.2%, while in Europe, the German 10-Year Bund reached a peak of 2.6% having started the year in negative territory at -0.2%.
The famous military general and author of ‘The Art of War’, Sun Tzu, is well known for his quote that states “in the midst of chaos there is also opportunity”. This quote has not been lost on bond investors. Based on Bloomberg data at the end of May, the exchange traded Fund (ETF) that has attracted the largest capital flows of any asset class in 2023 is a long-duration US Treasury ETF, with over US$10.37 billion of inflows.
A brighter future
For investors with a long time horizon, interest rates moving higher are not necessarily a bad thing. To reflect the new higher yield environment, providers of Capital Market Assumptions (CMA) revised their long-term return forecasts higher for fixed income entering 2023. Figure 2 below shows how the level of starting bond yield and the resulting future returns are highly correlated. The recent yield reset is welcomed by long-term investors.
The short to medium-term risk-return profile for government bonds has also improved. However, in a similar guise to the path of future monetary policy decisions of developed economy central banks, the outlook for fixed income remains uncertain and ‘data dependent’. For this reason, it makes sense to consider several potential scenarios.
1. Positive scenario (interest rates and bond yields fall)
The most positive scenario for government bonds is one where interest rates move lower. What is required for this outcome to unfold? One route is that restrictive monetary policy eventually dampens demand to the point where economies like that of the US fall into a recession and central banks are forced to cut interest rates to stimulative levels. Inflation would also need to fall back close to central bank targets.
During previous US recessions, the yield on the US 10-year Treasury bond has compressed by approximately 3% on average from peak to trough. A similar move in bond yields today would result in a handsome return for investors, providing significant diversification benefits in an environment where equity markets are likely to weaken.
In the absence of a recession but where inflation returns to acceptable levels and enough slack is created in labour markets, interest rate cuts are also a possibility over the next 12 – 18 months. Rate cuts in this outcome would be of a smaller magnitude than in a recession scenario, with interest rates reverting closer to neutral rather than a lower stimulative level.
2. Neutral scenario (interest rates and bond yields remain range bound)
In the absence of interest rate cuts from central banks and where bond yields remain range bound; investors are at least being compensated to hold bonds at more attractive levels of yield. This will reduce the opportunity cost of holding government bonds in comparison to alternative investments.
In addition, we believe that there is a strong possibility that an inflection point is approaching in rate hiking cycles, particularly in the US. Investors can take some comfort that if this inflection point comes to fruition – history suggests that bond yields tend to peak a couple of months either side of the last rate hike being implemented.
3. Negative scenario (yields move higher as central banks are forced to increase rates further)
Government bonds do not like inflation. So, it is no surprise that the ‘negative’ scenario for bonds is one where inflation remains entrenched, forcing central banks to increase interest rates to a greater extent than the market is anticipating. The potential return in the scenario is less favourable than scenarios one and two, however, two factors will help to limit the potential downside.
i) Market pricing for central bank rates is quite generous particularly for the European Central Bank and the Bank of England, leaving quite a high hurdle for central banks to overcome.
ii) The higher level of starting yields will help to cushion/limit the negative impact of yields moving higher from here.
How is Davy reflecting fixed income market developments in portfolios?
Davy discretionary portfolios benefitted from an underweight allocation to fixed income and an underweight duration stance in 2022. Since late last year, we have reinstated the duration of the fixed income bucket close to the benchmark duration.
As central banks appear to be approaching the end of their hiking cycles, a reduction in the current underweight position to government bonds is under consideration. Although we do not believe that a recession in the US is imminent, there is a strong possibility of rate cuts in 2024, from which government bonds would directly benefit.
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