Few questions preoccupy investors' minds more right now than the direction of interest rates.
Most fixed income assets rose steeply in the final quarter of 2023 as investors began to price in a series of cuts to base rates being implemented by, respectively, the US Federal Reserve, the European Central Bank and the Bank of England.
In particular, market participants rushed to buy bonds with a longer date to maturity and high-yield bonds.
Falling base rates make longer-dated bonds relatively more attractive as investors seek to lock in today’s higher yields for the maximum possible time, as lower base rates will drive down the yields on bonds issued in future.
What you do need to do is be nimble, given all of the uncertainty in the world.James Ringer, SchrodersHigh-yield bond prices tend to rise when markets expect rate cuts because investors with income as a priority move to the highest-yielding part of the fixed income universe, as they anticipate yields falling in the lower risk areas.
The second reason high-yield bonds tend to do well when rates are falling is that rate cuts are designed to stimulate economic activity, and increased economic activity raises the likelihood that the company or country will be able to repay the debt.
But while markets reacted rapidly to price in rate cuts, since the start of 2024 there has been a reassessment of the outlook for monetary policy, with central banks signalling caution on the timing and extent to which monetary policy is loosened.
Amid such uncertainty, how can fixed income allocation be positioned for returns in the coming years?
Pimco economist Nicola Mai says: “Looking ahead, in our baseline scenario (where we envisage both growth and inflation slowing), bond yields will likely be anchored. But if you have a deep recession, bonds are likely to outperform – and may perform better than equities.
"Finally, if we experience a “sticky inflation” scenario, that will hurt bonds as well as equities; however, equities will get hurt by the tighter monetary policy expectations, whereas with bonds investors still have the coupons to cover some of these losses.”
Amundi investment manager Jacques Keller tells FT Adviser the market is essentially divided into two types of investors right now.
He says: “In one corner of the market, you have money market investors enjoying high yields but increasingly concerned about their re-investment risk. In the other corner, you have long-duration investors dealing with rate volatility and the inverted term structure of rates. Admittedly, the latter has lower re-investment risk.
"We believe a diversified allocation to short to intermediate bonds should be part of the solution.”
Keller says the risk for the investors holding cash and very short-dated bonds is that as they mature, the new rates offered will be lower than the current rates, altering the investment case for that part of the market.
Endurance test?
Those owning longer-duration assets run the risk that if rates do not fall, or inflation spikes, then the capital appreciation they are expecting does not happen.
Schroders fixed income investor James Ringer says the levels of uncertainty, both in terms of monetary policy, but also election outcomes around the world, make it “difficult to have a multi-year view” right now, and so he says he does not want to be at either extreme of the bond market.
But he says the great advantage bond investors have in the current climate is that, in his view, “you don’t need to take a lot of interest rate risk to get a decent yield right now, and you don’t need to take a lot of credit risk to get a decent yield. But I think what you do need to do is be nimble, given all of the uncertainty in the world.”
Wesley Coultas, head of investment management at Walker Crips, is among those focused on shorter-duration bonds.
His view is that bond market volatility has been such that taking the 4 per cent yield offered by short-duration gilts is prudent, while he says the prevailing economic climate is sufficiently uncertain that he prefers not to take much credit risk.
In order to enhance the yields on some portfolios, he invests in the subordinated debt of well-established companies.
Subordinated bonds have a higher yield because one is effectively second in the queue for repayment behind those who own the first-tier bonds, though one is lending to the same company as the lender of the top-tier bonds.
Christopher Joye is chief investment officer at Coolabah Capital Investments. His view is that it is very hard for a bond manager to add value by predicting interest rate movements and getting the duration right.
So rather than allocate client capital to strategies predicated on being able to do this, he focuses on the prices at which bonds trade at any given time, and with that as a priority he says that right now some of the longer-dated government bonds offer attractive yields.
Matthew Morgan, head of fixed income at Jupiter Asset Management, says building an exposure to corporate bonds that is “recession proof” is likely to be key to delivering positive returns, as he continues to expect economic conditions to deteriorate from here.
Edward Harrold, fixed income investor at Capital Group, says the bulk of returns for bond investors in the coming year will come from the income paid on bonds, and so he is focusing on assets with lower credit risk that offer yield, rather than trying to take more risk on the basis of then being able to profit from the rise in price of some bonds.
David Thorpe is investment editor of FTAdviser
