Fixed income in 2024: what investors should expect

It has been a tough few years in fixed income markets. Rather than the ‘safe’ part of an investor’s portfolio, bonds have been volatile and unpredictable. However, with yields high, risks diminishing and the economic cycle turning, bonds may once again fulfil their traditional role in a portfolio in 2024, providing a bulwark against equity market volatility and a source of reliable income.

Setting the scene

Fixed income has had to struggle against mounting inflationary pressures and rising interest rates over the past two years. It didn’t help that yields had been at record lows, leaving little margin for error when the environment turned. The average fund in the IA UK Gilt sector is down 28.6% over three years*. Investors in IA Sterling Corporate Bond funds have fared slightly better, but are still nursing an average loss of 12.9%*.

This has created significant value in fixed income markets, with yields at levels not seen in more than a decade. The US 10 year treasury yield has dropped from almost 5% since the summer to its current level of 4.2%, but as recently as January 2022 yields were below 2%**. Government bond funds may deliver a yield of 4-5%, with investment grade corporate bond funds offering 1-2% more. Yields on high grade government bonds are finally ahead of inflation.

More importantly, interest rates and inflation appear to have stabilised.

This means fixed income funds may once again have real appeal for investors weary of stock market volatility. The latest IA statistics show money flowing into government and specialist bond funds plus UK gilt funds, in an otherwise grim market for fund flows***.

Colin Finlayson, co-manager of Aegon Strategic Bond fund, says: “After three years of tumultuous returns from a high interest rate, high inflation environment, fixed income markets now look poised to benefit as we head into 2024. The rise in yields over 2023 leaves valuations in credit and sovereign bond markets at levels not seen in 15 years… Bond volatility is peaking, and current yields provide an attractive entry point for investors looking to gather equity-like returns in the medium term for lower volatility.”

Listen to our recent podcast interview with Alex Pelteshki, co-manager of Aegon Strategic Bond, about all things fixed income.

Risks dropping

Many of the risks that have weighed on fixed income markets appear to be ebbing. For example, it is difficult to find fixed income fund managers who believe inflation will revive.

For Richard Woolnough, manager of M&G Optimal Income, the key variable is the reduction in money supply. He says that while central bankers are happy to assume that the price of goods or services is sensitive to supply, they don’t believe the same is true of money and therefore may be missing deflationary pressures in the system.

Having increased the supply of money and created inflation, central bankers are moving in the opposite direction, removing money from the system.

“All supply chain bottlenecks are gone, so we now have less money, chasing more goods. That does not sound inflationary to me,” he says. If central banks keep withdrawing money from the system, effectively ‘cancelling’ money, it could be deflationary. “If there was to be a surprise, it will be that inflation comes down more than people bet.”

That said, he does not believe that the outlook for the global economy is necessarily particularly gloomy as a result. He says: “It is possible to imagine that by the end of Q2 next year, employment will have gone from hot to warm, inflation will have reverted to target, but rates will remain at 5-6%. At this point, central banks will be primed and ready to act if there is a shock to the economy or recession.” Colin Finlayson agrees, “while we do predict negative economic growth in the beginning of next year, we expect a recession to be relatively benign.”

Read more of Richard Woolnough’s views: investment insights for 2024

In this environment, corporate credit can still thrive. A ‘soft’ landing might see a marginal rise in defaults, but not enough to destabilise corporate bond markets. However, a number of bond fund managers are predicting a gloomier outcome.

Ariel Bezalel, manager of the Jupiter Strategic Bond fund, believes major developed markets economies are going to see a material slowdown and, most likely, a recession. This would be a far tougher environment for corporate bonds, with defaults rising more sharply. Credit spreads over government bonds currently leave relatively little margin for error.

Mike Riddell, manager of the Allianz Strategic Bond fund, also takes this view. He says: “No one is expecting a hard landing or worse as a base case. That is definitely our view … Soft landings don’t really exist. It’s either no landing or a hard landing, there’s not normally anything in the middle.”

He believes weakening commodity prices have supported the global economy, but there is still pain to come as interest rate rises work through the system. Both Mike and Ariel have adopted a long duration stance in anticipation of falling interest rates, with a focus on government bonds.

Colin’s approach is softer: “We are adding duration in the US, Europe and UK with the expectation that respective central banks will cut rates at some point next year. Government bonds, investment grade and higher-rated high yield credit are all attractive in this instance, and we are actively invested across all three categories. We particularly favour investment grade, given our preference for duration as well as our expectations of an economic slowdown.”

Explore all Elite Rated strategic bond funds

Where to invest?

Government bonds will receive the strongest boost from any cut in rates, particularly longer-dated bonds. For corporate bonds, spreads are not particularly wide by historic standards, and may not give sufficient margin for error should the ‘hard landing’ scenario emerge. There are signs that corporate bond fund managers are starting to avoid the lower end of the credit spectrum in expectation of a pick-up in defaults.

Investors face a choice. If they believe in the ‘hard landing’ scenario, where inflation drops significantly and economic growth evaporates, prompting central banks to cut rates, the Allianz Strategic Bond fund and Jupiter Strategic Bond funds will reflect their views.

If they believe in a softer landing, they can introduce more credit exposure, but they will need to pick their fund manager with care. The Rathbone Ethical Bond fund or TwentyFour Corporate Bond fund could be options in that scenario.

The real risk to bond markets is the third scenario – no landing at all. The US continues to see strong economic growth and labour markets are buoyant. Fixed income markets remain highly sensitive to any potential revival in inflation. As recently as summer 2023, there were concerns that rising commodity prices would tip it higher again and, potentially, force action from central banks on rates. Soaring growth remains unlikely, but investors should be alert to the possibility.

For more insights into the global bond market, we recommend our interview with Eva Sun-Wai, fund manager on the M&G Global Macro Bond fund, who goes into detail on the the global macro economy with nuanced perspectives on interest rates, inflation, fiscal policy, and monetary policy.

*Source: FE Analytics, total returns in sterling, 11 December 2020 to 11 December 2023

**Source: Marketwatch, 12 December 2023

***Source: Investment Association, October 2023