Where will bond returns come from over the rest of 2024?

Iain Stealey, a bond investor at JP Morgan Asset Management, says the challenge that investors have faced since rates began to rise in the US is that, while the yield available has risen, the potential for further rate rises creates the risk that bond prices could fall, causing losses greater than the gains available from the higher income paid on the bonds.

Stealey’s view is that with interest rates in global developed markets unlikely to rise from here, “that risk has been removed”.

While there may not be much capacity for bond prices to rise as much has, in his opinion, already been priced in, “you can enjoy the nice yields knowing the risk of further rate hikes has been taken away.

"Also, you have optionality that, if the economy does turn down, which we don’t expect, then bond prices may rise and that is where the capital gains may come in.”

He anticipates that for the rest of this year, and potentially into next year, the income available from a bond, known as “carry”, will be the main driver of returns. 

Indications of cuts

Stealey’s view that there may not be much room for capital gains from bonds in the near term is based on two factors. 

The first is that he believes current economic data is positive, and doesn’t point to a recession, reducing the potential for bonds to be a safe haven.

The second is that he believes the sharp rally in bond prices in the final quarter of 2023 “was a sign of too much enthusiasm” among investors as they began to price in up to six rate cuts.

Stealey says the US Federal Reserve has indicated that three rate cuts are likely at some point this year, and the bond market is now priced for close to this level, implying bond prices may be close to fair value, as long as no significant economic downturn occurs. 

His view is that an economic “soft landing” has already happened, and that rate cuts have the potential to extend the period of economic positivity. 

Roman Gaiser, head of fixed income at Columbia Threadneedle Investments, is another who is keen to focus on the higher yields available from bonds, particularly government bonds.

He says his focus has been to “lock in the yields for as long as possible”, and with that in mind has exposure to bonds with a long date to maturity. 

You have optionality that, if the economy does turn down, which we don’t expect, then bond prices may rise and that is where the capital gains may come inIain Stealey

With that in mind, he is relatively cautious about taking credit risk - such as buying bonds that have a credit rating of below investment grade - as he anticipates defaults will rise.

Simultaneously, he views the spread - the extra yield available for the extra risk - to be unattractive right now.

On the topic of spreads, Stealey agrees, noting that the spread offered to own a high yield bond instead of a government bond is presently 3 per cent, a level he describes as “not particularly attractive".

But he believes the absolute level of yield offered, at around 8 per cent is attractive, particularly in an environment where rates are being cut.

Stealey says the market “has done a good job” of pricing the better quality bonds at higher prices than the lower quality bonds, meaning there is no obvious valuation opportunity, even if the headline yields are attractive on the higher quality bonds. 

Where are they allocating?

Chris Justham, managing director for intermediary solutions at 7IM, says that when rates were low, his company tended to focus their fixed income exposure on credit and short duration assets, but that the advent of higher rates has prompted the firm to increase its allocation to longer duration assets. 

Paul O’Neill, chief investment officer at wealth management firm Bentley Reid, said one advantage of higher bond yields right now is that in multi-asset client portfolios, income coming from a lower risk portfolio enables more risk to be taken elsewhere. 

These are all conversations that advisers and clients may well be having more of in the months to come.