Bonds are back on the table as value emerges

The first half of 2022 was a bracing period for investors, with equity and bond indices registering their worst first half returns for about half a century. Rampant inflation was largely to blame, forcing the US central bank (the ‘Fed’) to increase interest rates by the greatest margin since 1994, despite previously ruling out such a scenario.

However, the market backdrop is evolving. “Over the last month or so, there has been a noteworthy shift in how the market perceives the ongoing battle to curtail rising prices,” commented Vincent Ropers, manager of the TB Wise Multi-Asset Growth fund. “It appears inflation is now very much a known risk and largely priced into markets, with the risk of global recession now seemingly taking its place as the principal concern among investors.”

Analysis of the US two-year breakeven rate, which provides a good indication of the level of inflation in two years’ time priced in by the market, indicates we are past the peak in inflation expectations, according to Vincent.

“In March, the rate suggested about 4.7% of inflation was priced in. Today, this figure has fallen to 3.2%, indicating within the space of just three months, inflation expectations have declined 1.5% in the US for the next two years,” he said.

“The commodities market also implies recession fears are trumping those of inflation. The price of copper, which is a strong indicator of industrial activity, has fallen off a cliff in recent months, while the prices of other key industrial metals including aluminium and even silver have also witnessed considerable declines.”

On board with bonds

According to Vincent, this marked shift is unearthing compelling opportunities in assets previously out of favour with growth investors. “Specifically, we believe pockets of fixed income look increasingly attractive in the macroeconomic environment fast emerging,” he said.

This is a view echoed by Colin Finlayson, co-manager of Aegon Strategic Bond fund. In a recent video interview with FundCalibre he said, “I think we are approaching a period where the outlook is much more constructive. There are two key elements here – the peak in inflation, which we expect to come in the second half of the year, and alongside that interest rate expectations, or how much the central banks are going to hike rates.

“A lot of that is very well known and a lot of that is now priced into the valuations of bonds. At the same time, a much higher level of defaults is implied than we think is going to be realised. So, from a valuation standpoint, this has become a very attractive time to be adding additional fixed income risk into your portfolios.”

Allocating towards traditional bond strategies

“Although high inflation and rising interest rates are generally strong hurdles for the fixed income market, a good degree of downside already being priced in means yields now offer a greater degree of protection, at around the 3% level in US 10-year government bonds, 2% in the UK, and 1% in Europe,” continued Vincent. “With the recession risk now looming large, we believe traditional bonds should increasingly act as a diversifier to equities.

“In recent months, bonds have increasingly performed well when equity markets have struggled. In the first half of the year, the S&P 500 was down 20%, while the broad US aggregate bond market was down 10%. Since the 1970s, this is the first time bonds have not delivered positive returns when equities dropped by such a magnitude.

“With current bond yields offering a greater margin of safety, we feel a compelling opportunity has arisen, and we are subsequently allocating towards traditional bond strategies for the first time in years.”

Vincent has recently added some bond funds to his portfolio, preferring those that are tilted towards companies rather than governments which is “a much more natural fit for multi-asset growth strategies.”

Don’t forget floating rates

“While a moderate allocation to traditional bond strategies seems sensible at present, it is also vital growth investors do not overlook wider areas of fixed income that remain compelling in the current inflationary environment,” said Vincent. “Specifically, investors can ensure an attractive level of portfolio diversification by allocating towards bond strategies that invest in asset-backed securities.”

One company that specialises in asset-back fixed income securities is TwentyFour Asset Management.

“The quality of the credit work from the team at TwentyFour provides protection on the downside, while the fact asset-backed securities use floating rather than fixed rates – whereby coupons payable rise in tandem with interest rates – offers a meaningful hedge against rising rates,” Vincent said.

“As such, a sensible allocation to bond strategies can provide considerable portfolio protection amid an increasingly uncertain macroeconomic environment, as well as the potential for attractive capital growth over the near and medium term.”

The greatest probability of a decent positive return

Chris Bowie, manager of Elite Rated TwentyFour Corporate Bond and TwentyFour Absolute Return Credit funds also believes there are key reasons why investors should consider putting their faith in corporate bond funds at the moment. “The aggressive repricing of fixed income over the last nine months has taken corporate bonds to their best yield levels in years,” he explained.

In particular, he outlined the prospects for higher quality investment grade corporate bonds. Here, he thinks the entry point now is very attractive, especially when comparing to more volatile asset classes or those more exposed to the economic cycle, as we deal with the risks of recessions worldwide over the next year or so.

“Whilst the deeper parts of the high yield market remain too risky for us (and have default concerns as we move into 2023), by contrast in investment grade we think the market has moved too far in pricing in a doomsday scenario that to us is way overblown,” he said.

While Chris accepts that there will be losers over the coming months on the back of further rate hikes and the risks of recession – even within investment grade credit – he believes there are still plenty of potential positives for investors to consider.

“Provided you stay away from deep cyclicals and companies needing immediate refinancing, we believe the yield on offer more than compensates for these risks,” he said. “In fact, that higher level of yield now available gives the greatest probability of a decent positive return over a one year holding period that we have had in literally years.”

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