Finding opportunities in the fixed income universe

Higher inflation is, of course, typically very bad for bonds, as has been seen this year with the IA Sterling Corporate Bond sector losing more than 9 per cent, a performance worse even than the returns of a money market fund, which just holds cash. 

And, unlike with some parts of the equity market, the type of inflation percolating through the economy is largely irrelevant to the bond market, all inflation is a negative.

But Funk says that while most of the focus is on the supply-side inflation, he says there is some demand-side inflation in the economy as well, and the latter means that more economically sensitive areas of the bond market, such as high yield, can perform well.

He says the inflation has probably reached its peak and will start to come down in the months ahead, which is also likely to boost bond returns. 

Those areas of the bond market are also interesting Bryn Jones, head of fixed income at Rathbones. 

One would have to say that a lot of bad news is priced into bond market valuations.Bryn Jones, Rathbones

He says that while a recession “is a possibility” it is not a certainty, but bond markets are presently pricing in a very severe economic outcome.

He says in the investment-grade bond universe, that is, bonds with a credit rating of BBB or higher, bonds in aggregate are presently priced as though 6 per cent of them will default on payments, while Jones says the historic average default rate in this area of the bond market is around 1 per cent. 

Jones adds that high yield bonds, that is, those with a credit rating of below BBB, are priced to reflect default rates that have not been seen since 1970.

While keen not to make an economic forecast, Jones says: “A recession might happen, but it is not a given. Unemployment is very low, while Purchasing Manager Index (PMI) survey data is in positive territory (indicating economies are expanding), and in that climate one would have to say that a lot of bad news is priced into bond market valuations.” 

Of course, from an income perspective, it is the level of yield that matters to investors, and while bond yields have risen this year, inflation has risen even faster, meaning bond yields remain negative in real terms, that is, the yield is lower than inflation so the spending power is diminishing. 

Government bonds

Specifically with regard to government bonds, many regard them as a sort of portfolio insurance, a position held on the basis that government bonds, in particular, are likely to perform better in the event of equity markets under-performing. 

The challenge for investors over the past decade has been that while the bonds may act as insurance in times of strife, the yields on those assets have been very low, or even negative, even before inflation was considered.  

Ben Gutteridge, who runs the model portfolio service at Invesco, has recently been buying more government bonds at the same time as increasing his equity exposure, on the basis they perform inversely to each other.

A recession over the coming 12 to 24 months is not out of the question in a number of jurisdictions.Roger Webb, Abrdn

The fact yields have risen means clients receive slightly better income than in the past, but this is not the central reason for Gutteridge’s investment, as he feels inflation will soon peak and yields will stop rising by quite so much.

But Roger Webb, deputy head of sterling investment-grade bonds at Abrdn, says yields are in nominal (ie without inflation) at the highest level they have been since 2014, and he thinks this will contribute to investors increasing their bond allocations in the coming months.

He says: “The higher yields now on offer present an opportunity that hasn’t been seen for some time. UK investment-grade credit hasn’t offered yields like those on offer now since 2014 and while high yield and EMD have seen bigger spikes [in March 2020], both markets are offering all-in yields that have seldom been seen in the past 10 years.

"With inflation touching double digits, these yields will clearly fail to keep pace, but assuming price rises slow over the coming years as policy tightening bites and economic growth falters, we believe that some value is definitely emerging."

Webb adds: "There are risks for the period ahead. With high inflation and rising rates, the consumer sector is feeling the pinch in the UK and elsewhere. As a result, a recession over the coming 12 to 24 months is not out of the question in a number of jurisdictions.

"This would, most likely, have negative implications for riskier assets such as equities and high-yield credit, but often these markets price in the risk before the event. An uncertain future often leads to volatility, but this can provide opportunities.”

From an multi-asset perspective, the higher yields contribute to higher income today, while, in the event of a recession, bond prices would likely rise as investors seek the protection of bonds.

This would reduce the level of income available, but the level of income from equities would also be falling in a situation whereby a recession was causing company earnings to fall rapidly. 

Governments would, in all foreseeable circumstances, be able to repay debts, so government bonds would offer a measure of protection for income investors in a downturn. 

david.thorpe@ft.com