The increasing likelihood of a steep downturn in the US economy combined with valuations being at low levels means now is an attractive time to invest in bonds, according to Ian Brady, chief investment officer at WH Ireland.
Bonds have sold off sharply in 2022, with the IA Sterling Corporate Bond sector down 19 per cent as investors fear not just the impact of higher inflation on the spending power of the income paid on the bonds, but also the impact of the higher interest rates on bond prices.
Brady has for some time been sceptical on the investment case for bonds, but this month has increased his investment in the asset class.
He says recent economic data to emerge from the US indicated economic activity had begun to slow, but with the US Federal Reserve continuing to focus on driving inflation down, he didn't feel the decline in growth would lead to a change in central bank policy.
That implied to him that the Fed will be putting interest rates up into a slowing economy, which would lead to what economists call demand destruction, and an economic slowdown.
He adds that other data points indicate the supply chain issues which drove much of the global inflation prior to Russia’s invasion of Ukraine are beginning to dissipate.
All of that means, he says, that "inflationary expectations will be significantly lower within a year".
Inflation falling would typically be positive for fixed income assets, as it means the spending power of the interest received would be worth relatively more, while central banks would have less incentive to raise rates.
This has prompted him to increase bond allocations, saying: “Increasing yields and spreads have left many parts of the bond market far more favourably priced, with WH Ireland deciding to add to an existing holding in the high yield market while taking its first foray into emerging market debt. Preference for corporate debt over gilts due to corporates being in better financial shape than previous crises and offering a more attractive risk/return. Preference [is] toward bond funds that are less exposed to rises in interest rates, seeing little need to take on extra interest rate risk in a volatile market environment.”
Another investor who is developing a growing affection for bonds is David Jane, multi-asset investor at Premier Miton, who holds the long-term view that inflation will be higher, but says he has started to “tentatively” buy more corporate bonds as a result of yields being high.
Ariel Bezalel runs the £3.4bn Jupiter Strategic Bond fund. This fund has struggled in performance terms in recent time due to being quite long duration, a position one would take if one felt inflation would be moderate.
Belazel continues to feel that a profound economic shock is on the way, saying he sees three areas of major risk for the global economy: the tightening in financial conditions, China and the housing market.
On the last of these, he said: "While China has its own housing problems many developed markets are not in a bright spot either. After the parabolic growth in house prices experienced in the last few years, the US, Australia, New Zealand and the UK are now starting to experience more modest price rises and in some cases even falling house prices.
"Tighter financial conditions have made housing increasingly less affordable and while adjustable-rate mortgages are not a major problem in the United States, they are definitely a concern in the UK and in Australia.”
With that in mind he thinks “sharp” price adjustments could take place in future, and as all are negative for economic growth, the potential is for long duration assets to do well, following the inflationary period where shorter duration performed best.
In terms of where he is finding value, he says: “The recent widening starts to bring credit spreads in a more attractive territory. Looking at Europe for example, the lower quality segment of the investment grade market (bonds rated BBB by major credit rating agencies) and the higher quality segment of the high yield market (bonds rated BB by major credit rating agencies) are offering today spreads versus current yields on German bunds not too far from those seen during the Covid crisis. Even very defensive names in the telecommunication or healthcare space are offering today yields in the 7-9 per cent range.”
Edward Park, chief investment officer at Brooks Macdonald, said the higher yields offered on even short-dated government bonds was now "compelling".
He says: "The conversation with clients and advisers around bonds has changed. For a long time it was about how we needed to invest somewhere else to get yield because bonds didn't have much, but now the yield, even on the shorter maturity UK government bond is over 3 per cent, and as they are shorted dated, they are less sensitive to interest rate rises."
Traditionally, an investor who is seeking protection from recession would buy longer dated bonds. This is because the traditional response of policy makers to a recession would be to cut interest rates, and therefore the longer the income is locked in on the bonds issued before the rate cut happened, the more valuable those bonds are.
But, continuing the theme of bonds reacting differently, Park said we could well have a recession where inflation remains high, and, with central banks focused on fighting the latter, rates could still rise, sharply hurting the price of longer dated bonds.
Simon King, chief investment officer at Vermeer Partners, is another investor keen on bonds right now, and also on the short end of the curve.
He says: "Bonds are definitely becoming more interesting. We have avoided them for some time but are now having a serious look. We are still bearish on inflation and as such believe interest rates will peak higher and stay higher for longer than the market currently anticipates.
"As such we think three may be a better entry point on government bonds in the next couple of months. Once the decision to go into bonds is taken next key question is maturity and we would stick at the short end of the curve given uncertainty of long-term macro outlook. Then it is a question of how much US government to buy compared to UK government.
"We have to take a view on exchange rates and where inflation will go which is not easy given US inflation is more demand side and domestically generated where as UK is suffering from supply side, global trends and Brexit."
david.thorpe@ft.com
