Talking PointMay 25 2023

Bonds: striking right balance between income and value is 'paramount'

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Bonds: striking right balance between income and value is 'paramount'
Ekaterina Bolovtsova via Pexels

Striking the right balance between income generation and preserving value in bonds has become paramount in the current volatile landscape, according to Scott Gallacher, director at Rowely Turton.

This is because in today's bond market, UK investors face a twofold challenge: rising yields offering apparent income opportunities, yet undermined by high inflation. 

Gallacher added: “While higher yields might seem attractive, it's crucial to remember that inflation erodes purchasing power, leaving investors with negative 'real' yields.”

The most recent inflation data published yesterday showed that it fell in April to 8.7 per cent from 10.1 per cent in March.

Although inflation has eased, the outlook is still uncertain with more rate hikes expected to bring it down further.

Rob Morgan, chief investment analyst at Charles Stanley said the recent rise in government bond yields was indicative of a leaning towards higher and longer-lasting inflation than previously anticipated. 

He added: “Financial markets are presently balancing the wide range of outcomes for inflation both globally and in the UK. For instance, the ten-year gilt yield is presently around 4.1 per cent having started the year at around 3.6 per cent. 

“This is keeping a lid on asset prices across the board as investors try to factor in the appropriate level of inflation and interest rate risk. All else being equal, higher inflation and interest rates to combat them is negative for most asset prices as investors require a higher rate of return, implying a lower starting value.”

Despite the uncertain global growth outlook and inflation remaining sticky, a recent note from Alliance Bernstein said opportunities remained in corporate bonds.

The note by Tiffanie Wong - senior vice president and director of fixed income responsible investing portfolio management and Timothy Kurpis, portfolio manager of investment grade credit., said: "At first blush, corporate fundamentals appear to be softening, with top-line growth and earnings showing signs of slowing. But context matters.

"This inflection is coming from an initial position of strength. Both revenue growth and profit margins are coming off their highest levels in more than a decade. Moreover, issuers are managing their balance sheets conservatively, with both operating and sales costs declining as a percentage of revenue."

First-quarter earnings from investment-grade issuers have generally proven resilient, despite the unpredictable macroeconomic environment, the note added.

Meanwhile, for investors considering investment-grade corporates, the note said that valuations could make for a good entry point:  "Average prices for US dollar and Euro-denominated investment-grade bonds are at their lowest levels since the global financial crisis, due in large part to elevated interest rates. Lower prices should help to limit potential downside should the market experience volatility. 

"Meanwhile, global investment-grade credit spreads - the difference between corporate bond yields and government bond yields - have climbed back above long-term averages

"Of course, investment-grade bonds come with different risk/return profiles, and it’s important for investors to do their due diligence. In today’s volatile environment, high-quality bonds help investors play defense, but we also see some opportunities in select lower-rated investment-grade credit.

"The coming months are likely to offer another dose of mixed economic news. It can be difficult to make sense of it all and allocate assets accordingly. But given sound corporate fundamentals, compelling valuations and strong asset flows, we believe that investment-grade corporates deserve a closer look."