- Bonds look cheaper than they have done in a long time
- We assess the outlook for 2023
Bond markets have set all manner of questionable records in 2022. With sky-high inflation and interest rate rises bearing down, yields on benchmark government bonds in the UK and US have hit their highest levels in a decade, equating to big price falls and heavy paper losses. As of early December, the Investment Association’s (IA) UK Index Linked Gilts peer group was sitting on a loss of more than 30 per cent for 2022 – putting it on track to be the worst performer out of nearly 60 IA sectors. Bond investors in general have had a year to forget: at the time of writing the average fund in every single IA bond sector had recorded a loss this year. Just three of almost 90 funds in the Sterling Strategic Bond sector, home to more flexible fixed-income funds that tend to be the most adeptly positioned, were sitting on a positive sterling return for 2022.
To take a positive view, bonds do now look attractive by plenty of measures. Yields, which move inversely to prices, look more compelling both on bonds normally dubbed “safe” and those seen as riskier: yields on 10-year UK and US government bonds, traditionally seen as defensive assets, are around 3 per cent, while racier areas such as high yield and emerging market debt can offer much more. This is good news: higher yields have more scope to fall, creating at least the potential for capital gains. More significantly, in many cases the yields alone arguably offer a compelling opportunity for income investors.
Some veterans of the bond market have certainly taken such a view. Chris Bowie, a partner at fixed-income specialist TwentyFour Asset Management, recently noted that the starting yield on the ICE/BAML US Broad Market index of government and corporate bonds – which has tended to act as an indicator of the strength of returns for the next five years – has spiked. With the collapse in yields seen during more than a decade of quantitative easing having reversed this year, the index now offers the highest starting yield since 2008 and a promise of strong five-year returns. Its recent starting yield of 4.98 per cent predicts annualised average returns of 5.61 per cent for the coming five-year period.
If this seems overly simplistic, others have additional reasons for optimism. Chris Iggo, chief investment officer at Axa Investment Management's core investment division and an experienced fixed-income specialist, believes the Federal Reserve is unlikely to raise interest rates much more before halting, with the same likely to be true for both the Bank of England and the European Central Bank.
“Rates are close to peaking in the US and the increases we have seen in bond yields in many markets means, going forward, the risk-return trade-off is much better for bonds. Higher yields mean lower bond prices and, even if yields don’t fall, bondholders will benefit from a strong pull to par as prices converge on 100 over the remainder of their maturity,” he says.
70s vibes
As with tech stocks and other investments that suddenly look cheaper, we should nevertheless ask if bonds are simply more realistically priced for difficult times. Some possible scenarios favour the bond investor: in particular, if inflation were to moderate and interest rate hikes were to slow, end or even reverse. But some have predicted a period of stagflation, where inflation remains high yet the economy is stuck in the doldrums. A look back at the 1970s, when stagflation was last a real issue for developed markets, suggests such conditions can be trying for bond and equity investors alike.
As Deutsche Bank head of credit strategy and thematic research Jim Reid and research analyst Henry Allen put it in a note earlier this year: “Equities generally saw losses in real terms in the 1970s, but energy was the best place to be on a sectoral basis, echoing 2022’s performance. Treasuries declined in real return terms too, although those with shorter-dated yields fared relatively better than their longer-dated counterparts, once again mirroring the 2022 performance."
Much has changed in the several decades since then, however, and differences in the global economy could well alter how a bout of stagflation would play out this time.
It’s also worth thinking about how the yields on offer and potential further volatility could change how bondholders behave. “In contrast to years of quantitative easing pushing yields down and prices up, returns are going to come more from income going forward,” notes Iggo. While total returns may ultimately be all that matter, a different and more long-termist mindset may be required of the bond investor from now on.
Playing safe or chasing yield?
No bond tends to ‘like’ interest rate rises but it’s worth reiterating the specific characteristics of different forms of debt. In a recession or a market panic, defensive instruments such as government and investment-grade bonds can perform well as investors seek a safe haven – although as this year shows that isn't always the case, thanks to their higher sensitivity to interest rate shifts. ‘Riskier’ forms of debt such as high yield are less sensitive to rate rises but do look vulnerable at times of economic difficulty, thanks to the possibility of issuers defaulting on their debt.
That’s certainly a concern for some of the more prominent managers of flexible bond funds. The team behind Jupiter Strategic Bond (GB00B544HM32), the biggest fund in the Sterling Strategic Bond sector, recently declared a “once-in-a-generation opportunity for fixed-income investors” but warned that selectivity would be needed for those buying corporate bonds, thanks to the increased risk of defaults in future. “We prefer defensive sectors and secured paper in areas such as telecom and cable for example,” the managers noted.
Defaults could certainly rise from a very low base as an economic slowdown kicks in, but there is some hope that such activity will be limited. Fitch Ratings, for one, has forecast that the US high-yield default rate will end 2023 at between 2.5 and 3.5 per cent, reflecting “growing macroeconomic headwinds” and an expected recession. However, this forecast is still below both the 3.8 per cent average of the past 21 years as well as 2020’s 5.2 per cent rate. Fitch has argued that a handful of large defaults will drive the default rate, with these concentrated in a few sectors. It predicts companies in the retail, telecommunications and broadcasting/media sectors alone will make up half of the default volume.
Returning to the flexible bond funds that hope to navigate shifts in the market, it’s worth noting the dividing lines between different teams when it comes to their trades and subsectors of choice. The managers behind the second-biggest fund in the sector, Janus Henderson Strategic Bond (GB0007502080), have been running a “significant” long-duration position, predominantly in government bonds, with a focus on a possible peak in interest rates and turn in employment data. Conversely, the fund has had much lower corporate bond exposure than some of its peers. Such calls could make a big difference to relative returns in future.
