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What's the outlook for investment grade bonds?

What's the outlook for investment grade bonds?

With yields high and the pace and scale of global interest rate rises now expected to moderate, investment grade bonds could outperform in 2023, according to Euan McNeil, bond manager at Aegon Asset Management. 

McNeil acknowledged that investment grade bond prices have risen stoutly since September, but said he continues to believe prices can rise further. 

He said: “Valuations continue to look attractive on an historic basis, even after the recovery seen since October. Meanwhile the interest rate outlook is relatively benign.

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"The pronounced slowdown in the UK economy - exacerbated by a tightening of fiscal policy - should limit the degree to which the Bank of England is required to raise rates.

"At the same time, inflationary pressures are gradually dissipating in the US and should ultimately limit the extent to which the Federal Reserve has to continue its policy tightening in 2023.”

The easing of interest rate expectations should provide support for investment grade valuations, says McNeil, who expects “this benefit most likely to be seen in the first and second quarters of 2023".

The most recent US inflation data has given some cause for optimism that we should see a lowering of interest rate expectations in the US.

He said: “Our preference continues to be for sterling and euro investment grade over dollar-denominated credit, with the sell-off seen in European and sterling credit over much of 2022 more pronounced than for the dollar market.”

McNeil’s view is that much of the sell-off in UK denominated corporate bonds in 2022 was a consequence of market concerns around the political outlook, which he feels has receeded and this will boost confidence in, and demand for, UK investment grade bonds. 

But Fahad Kamal, chief investment officer at Kleinwort Hambros, is very cautious on the outlook for the asset class right now. 

He said that while investment grade bond yields look attractive on the surface, “in reality the spread (gap) between the yield on government bonds and investment grade bonds is very low".

Kamal added: "While the top end of the investment grade bond market is full of companies that are not likely to default, the higher yields are from the lower end of the investment grade bond market, with ratings of around BBB, and those are companies that will be seeing their debt interest costs rise at the same time as their earnings are falling due to a recession.

"In that context, being invested in government bonds, where the default risk is almost zero, and the yields are positive, in some cases positive even in real terms, means we would rather own government bonds now.” 

Robert Tannahill, multi-asset investor at Ravenscroft said yields on investment grade bonds, even at the lower risk end, are attractive enough to justify inclusion in a multi-asset portfolio.

He said: “Bond income was not a realistic prospect for many years, but now it is again, you can get 6 per cent yield from a portfolio of sensible investment grade bonds right now.”