It's rare for bond managers to be excited about the prospects for their asset class – bonds were always meant to be boring.
But times have changed, and while that sadly hasn’t always been to everyone’s advantage (as the rollercoaster ride of that infamous "mini"-Budget illustrated), it’s time to seriously consider their role within an investment portfolio.
Interest rates are now the highest they have been in more than 15 years, a dynamic that has provided a boon for allocations to cash. The significant interest rate increases in the past two years has hit the bond market, leading investors to understandably seek refuge in money market funds.
However, with inflation fading and the interest rate cycle seemingly peaked, there are excellent opportunities in the bond market for both income and capital gains for years to come.
The last time interest rates were this high was in late 2006 and early 2007, however the current economic climate is very different. Economic growth is not booming, and interest rates are expected to decline.
The Bank of England is expected to cut interest rates soon, and while there’s never any guarantees this is generally very favourable for bond performance.
This is because yields tend to head lower after the first interest rate cut. For example, in the US, on average since the 1980s, the 10-year government bond yield has declined by almost 1 per cent on average in the 24 months after the first cut. Bond prices and yields behave like a seesaw: when bond yields fall, bond prices rise.
The UK bond market is entering a new era.Uncertainty is a constant in markets, but taking a step back and looking at the return prospects for bonds, they appear attractive in most scenarios. For example, looking at one to five-year maturity corporate bonds, the current yield is more than 5 per cent.
Where things get interesting is if interest rates are cut: if bond yields declined by 1 per cent, you generate approximately an 8 per cent total return with significant income and capital gains.
A scenario where things could get a little messier would be a supply-side shock, which is much harder to navigate than demand-side shocks.
This is because they impact growth (down) and inflation (up) differently, which means the BoE would have to prioritise either stabilising inflation or growth. In such a scenario, both government bond yields and corporate bond yields could rise.
However, its worth noting to generate a negative total return over a one-year holding period you would need yields to rise by more than 2 per cent as the high starting yields help to cushion capital losses.
Where to focus?
We find short maturity investment-grade corporate and government bonds particularly appealing. These investments can deliver strong total returns in most scenarios.
Shorter maturity bonds are likely to benefit from interest rate cuts, as the yield curve typically steepens following the initial interest rate cut. This results in shorter maturity bond yields decreasing more than their longer maturity counterparts, which is favourable for bond returns.
Moreover, the UK government has increased spending in response to Covid, following the trend set by its global peers.
This has led to a rise in bond supply, exerting some upward pressure on longer maturity bonds.
Government bonds, especially short maturity tenors, offer good value. Although short-term challenges may arise from stronger US growth and inflation, we foresee 2024 as the year of global divergence, with the BoE likely to cut interest rates.
Currently, five-year UK government bonds yields are yielding 4.2 per cent, almost 1 per cent higher than the UK consumer price index.
Likewise, for savers seeking protection against future price rises in the UK, inflation-linked bonds are currently offering a positive real yield, meaning you can lock in a savings rate above the inflation rate.
In the credit market, investment-grade corporate bonds offer good value.
Investment-grade corporate bonds have historically performed well in the 12 months following a central bank pause, as investors allocate to credit with attractive yields. Currently, investment-grade corporate bond yields are 2 per cent higher than the dividend yield on the FTSE 100.
Uncertainty is a constant in markets, but bonds appear attractive in most scenarios.Our favourite segment within the credit market is short-dated corporate bonds with one to five-year maturities.
These investments work in various scenarios and offer attractive returns. If government bond yields remain relatively unchanged, investors can benefit from an additional 120bps of yield. If yields fall, the asset class will produce strong returns.
If growth weakens and spreads rise, the decline in government bond yields should offset most, if not all, capital losses, ultimately leading to positive returns when factoring in the starting yield.
However, we are more cautious about high-yield debt, as its compensation relative to investment-grade corporate and government bonds is insufficient. For example, the yield on US high-yield corporate bonds relative to cash is currently at its lowest this century.
This certainly warrants some caution in higher risk segments of fixed income.
In conclusion, the UK bond market is entering a new era, with compelling opportunities for investors seeking income and capital gains over the medium to long term.
Thomas Maxwell is an investment director at Abrdn.
