Despite poor returns, investment bosses are increasingly optimistic about a bonds bounce-back and are recommending overweight positions for the recently troubled fixed income asset class.
Bond investors have had a challenging couple of years, with fixed income producing negative returns in 2021 and especially in 2022, as central banks sharply raised interest rates to combat inflation.
In 2022, the Bloomberg Aggregate Bond Index, a broad universe of US bonds, posted a total negative return of 13 per cent, the worst calendar year performance for this index since inception in 1976.
But a massive two-month rally in bond prices at the end of 2023, following a dramatic shift in investors’ expectations on interest rate cuts, rescued fixed income markets from a third straight year of declines. Today, with major central banks expected to pivot later this year, private banks’ CIOs are urging clients to make the most of high yields and include bonds in portfolios.
Locking-in yields
“Now is a good time to consider moving from cash to quality fixed income investments in order to lock-in high yields before they decline,” says César Pérez Ruiz, Pictet Wealth Management’s CIO.
Most of Mr Perez’s colleagues have a similar positive outlook on bonds, according to PWM’s ninth annual Global Asset Tracker study, which earlier this year surveyed CIOs and heads of investments at 54 private banks, managing more than $22tn in combined client assets. Around 50 per cent of them recommend clients have an overweight exposure to bonds, in line with last year. More than two thirds are confident allocations to fixed income will increase.
Bonds are expected to be better portfolio diversifiers than they have been in the past two years of high inflation and protect portfolios in case of recession.
Within the asset class, the strongest preference is for developed corporate and government investment grade bonds, with a focus on US Treasuries.
The US Federal Reserve raised interest rates 11 times in the 17 months to July last year, to 5.25-5.5 per cent, a speed in rate rises not seen since the 1980s. “Yields in the US have risen toward two-decade highs. We think investors should take advantage of them now,” says David Bailin, chief investment officer at Citi Global Wealth.
Inflation-adjusted ‘real’ Treasury yields of 2.5 per cent are higher than in 80 per cent of all periods over the past 25 years. Broader US fixed income yields are 4 per cent above expected inflation, he explains.
“Growth is likely to slow in early 2024, but we see no synchronised collapse across the global economy,” he predicts, echoing most private bank CIOs. The latter half of 2024 should show a return to sustainable economic momentum as well as an improvement in corporate earnings, with global economic growth expected to strengthen in 2025, according to Citi. The global bank expects a 12 per cent increase in earnings per share over the next two years. This means the two pillars of investment returns — income and growth — have been “reinvigorated”. “This a very good time to build new balanced portfolios or to add to existing ones,” says Mr Bailin.
“Clients should really try and get right that fixed income allocation, and get their high quality, fixed income exposure strategically aligned to their goals,” recommends Northern Trust Wealth Management’s CIO Katie Nixon.
“The massive rally in equities in 2023 is an opportunity to at least rebalance your portfolio, which in any given year is very good sort of portfolio hygiene,” she says. “It forces you to sell high and buy low, but more so this year.” In fact, many clients are “hoarding cash” for the purpose of investing in fixed income, but they are “nervous” to invest in the asset class.
But keeping cash on the sidelines is a bad move, “as the Fed may start to lower rates in a couple of months, and those very juicy 5 per cent plus, money market yields are going to go away pretty quickly,” she warns.
Interest rates are likely to fall in 2024, “potentially sharply”, which will reduce the return of cash and increase reinvestment risks. Beyond cash and money market funds, investors should diversify their liquidity strategy with a combination of fixed term deposits, bond ladders, and structured investment strategies to cover expected portfolio withdrawals over the next five years.
Thirst for yield
While conventional, investment grade quality bonds are employed for risk control in portfolios, the bank’s highest conviction call, US high yield, is seen as a “different animal”, says Ms Nixon. “That is very much a risk asset, aligned to longer term goals, with ability to withstand volatility.”
A high starting yield of around 8 per cent, an “insatiable thirst” for yield across the globe, a higher quality index than in the past, with a lower portion of triple Cs and higher proportion of Bs, position this asset class particularly well, says Ms Nixon, especially if coupled with the soft-landing economic scenario, along with probable cuts to Fed funds rate.
“We have liked high yield for a long time, it's kind of a lower risk way to get somewhat stock-like returns with lower volatility,” explains Ms Nixon.
While a recession would be positive for bonds, the biggest risk for risk assets, including high yield, is a recession. A repeat of the “boom bust cycles” that characterised the asset class in the past, particularly in the energy sector, is unlikely, though. The energy sector represented a big portion of the high yield market and responsible for defaults historically. “Those companies have certainly gotten religion around balance sheet conservation, using their cash flow wisely,” she adds.
Another “strange risk case” would be a reacceleration of the economy, as it would not give the Fed the ability to start to normalise interest rates. “With higher rates for much longer, then you start to bump up into that refinancing cycle that's coming this year, next year and the following year.”
High quality
Ms Nixon’s preference for US high yields is only shared by 20 per cent of CIOs, with the great majority focusing on high quality.
“We expect positive overall returns for both equities and bonds in the year ahead. But within each asset class, we believe investors should focus on quality,” says Mark Haefele, global CIO at UBS Global Wealth Management. “In fixed income, quality bonds offer attractive yields and should deliver capital appreciation if interest rate expectations decline, as we expect.”
Clémentine Gallès, chief economist and strategist at Société Générale Private Banking, predicts a favourable environment for corporate bonds in 2024, when the policies of the main central banks will “come to a head against a backdrop of falling inflation”.
“Given persistently high level of interest rates, bond markets remain attractive, especially highly rated corporate bonds,” she says. The French bank has an overexposure to the latter, “which not only offer an attractive carry but should also benefit from solid corporate balance sheets”.
Corporate debt in the current environment carries less leverage risk than in the past, observes Juan de Dios Sanchez-Roselly, global CIO at Santander Private Banking. This offers the opportunity to generate additional returns by investing in higher-quality segments of corporate bonds. “Investment-grade corporate bonds offer attractive risk premiums and compete favourably with equities on a yield basis, a situation that hasn't been seen in many years.”
Longer duration
His key recommendation to clients for 2024 is “to avoid the temptation of allocating too much capital to short term government bonds and to consider shifting to longer duration and investment grade corporates”.
“We believe there is value at the long end of the curve in the major geographies. It is worth positioning portfolios to capture this yield potential beyond the short term,” says Mr de Dios Sanchez-Roselly.
Meanwhile, higher yields make government bonds attractive, with these securities also providing diversification in the event of a “sharper economic slowdown”, he says.
While yields on short-term bonds are still attractive, this could also be the right time to “carefully extend” duration exposure, adds Pictet’s Mr Pérez. “Despite the recent fall in yields, there is still time to lengthen the duration of bond holdings. For instance, the fast decline in inflation means we like European investment-grade corporate bonds of up to seven years maturity.”
Others prefer to stick to short-dated fixed income. “With the current shape of the yield curve, we see no benefit in investing far out on the curve in credit,” says Gerald Moser, CIO and head of investment services Europe at LGT Private Bank. While long-dated government bonds should once again start to offer diversification in a multi-asset portfolio, he says, his preference is for high quality short-dated credit.
Others point out to attractive opportunities in the emerging markets local currency debt space. “We are long Brazilian sovereign debt, and we like similar fundamental stories, with positive real rates, a developing policy rate cutting cycle, and stable/supported currency,” says Christian Abuide, head of asset allocation at Lombard Odier.
Pictet’s Mr Pérez agrees that given continued yield pick-up and prospects for US dollar weakening, local currency emerging market debt is also “worth looking at again”.
While many have positive views for both equities and bonds, more than a third think bonds must be preferred to equities this year.
“Fixed income has better opportunities than stocks, as the risk premium has tightened,” says Larrainvial’s CIO Gonzalo Silva. While rates have increased from all time-lows in 2020, equity valuations have reached historical highs, especially in the US. “This low premium in a complex economic framework suggests that it is opportune to prioritise fixed income,” says Mr Silva.
Recession risk
Standard Chartered Bank’s CIO Steve Brice brings a different perspective. While overexposed to development market bonds, Standard Chartered Bank has a neutral allocation to fixed income, not increasing it to overweight because “we’re worried about slower growth”, explains Mr Brice.
“A US recession is not our central scenario, but there is 30 per cent of recession risk hitting, with risks likely to increase over time,” he says. Credit would be “very badly hit”.
“We’re not bullish on credit, we think spreads are very tight, particularly in the investment grade space, but also to a significant extent in the high yield space,” he says, explaining that debt issuance has fallen quite significantly, especially in high yield, because part of it has gone to the private credit market.
The bank’s central scenario is that the 10-year US Treasury yield comes down to 3.25 per cent by the end of the year, giving decent returns to investors. But it will also protect portfolios in case of a recession, with the yield getting closer to 2 per cent and generating greater returns, as prices rise.
Standard Chartered Bank has also a higher allocation to emerging market debt, believed to have better risk-return profile than other areas of the bond markets, not just from a return perspective, but also from a volatility perspective, says Mr Brice. “The risk is that inflation doesn't come down as quickly as people hope and that will create probably volatility across both equities and bonds.”
