A rebound for bonds

The level of inflation currently being seen in economies around the world has increased the appeal of fixed income as an asset class. Mihkel Kase assesses the current opportunities bonds are offering.

After an annus horribilis for fixed income markets in 2022, 2023 is shaping up as a much better year for this often-unloved asset class.

The past decade has been characterised by an environment of low inflation, low interest rates and high levels of liquidity, which propelled most asset classes to record levels, distorted risk pricing and created an unsustainable investment environment.

Now with the arrival of inflation, central banks have been forced to raise rates and drain liquidity in an attempt to reduce demand and fight inflation. This change in landscape has seen all markets, fixed income included, move through a transition phase as they adjust to rising interest rates, rebuilding of risk premiums and a return to less distorted pricing. It’s a tough environment for investors, but once we are through this period, the outlook will be brighter.

Going forward, active management will become more important – investors will need to discriminate as to where they allocate capital and will no longer be able to rely on excess liquidity driving asset prices. This transition, and the reset in both the level of interest rates and the credit spreads for corporate issuers, means the outlook for fixed interest markets has improved considerably for 2023.

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The general outlook

While there’s growing evidence inflation globally is peaking, it is less clear what its trajectory is from here and where it settles. A moderation in the inflation rate due to lower energy prices and easing supply chain pressures does not mean the fight against inflation has been won, particularly with labour markets globally still very tight. We do not expect a neat and linear return to the policy environment that prevailed pre-COVID and we think the market will be surprised by inflation stickiness, both in terms of the rate of inflation and the time it takes to revert to a sufficiently low level. This will present challenges to policymakers as they adjust interest rate settings and also for markets as they look to anticipate the reaction function of central banks.

There is a lot of speculation about whether there will be a hard or soft landing in 2023 as interest rates continue to rise and global economies slow. A hard landing would mean a deep recession. In such a scenario economic activity goes backwards and unemployment rises materially. In the soft-landing scenario, the outlook is not quite as grim. Growth might slow for a couple of quarters and unemployment would rise, but ultimately not a lot of damage would be done to profits or the economy.

Given where inflation is currently sitting, it is difficult to predict a hard or soft landing. If inflation remains stubborn and does not shift in response to interest rate rises by the central bank, the end result could look a lot like what happened through the 1970s – stagflation. However, we believe a soft landing is more likely where inflation falls in response to higher interest rates. We have positioned our fixed income portfolios accordingly, but we are watching developments carefully and ready to adjust to the changing environment.

New opportunities

Fortunately for investors, the pain of 2022 has seen a rebasing in sovereign yields and credit spreads in early 2023. Prior to this rebasing, if an investor wanted a yield of 5 per cent or more, they would have had to extend up the risk curve and look for investments in areas like global high yield or emerging market debt. Since the reset, however, investors are now able to access a yield of close to 5 per cent in investmentgrade markets.

Not only is there more yield on offer, but there’s also more dispersion across markets, which provides more opportunity. Importantly, investors looking for defensive income now have a much broader array of choices and don’t have to go further out the risk spectrum to chase yield.

We still expect a period of volatility ahead in fixed income markets, but we believe the rebuilding of yields across most investments means these markets will be able to deliver income and expected improved returns to investors.

In terms of our portfolio positioning, we are now looking for opportunities to increase exposure to both interest rate risk and credit risk via high-quality credit.

Last year we cut most of the interest rate risk out of our portfolios and reduced duration to close to zero. Our funds’ cash holdings moved to 50 per cent as we shifted strategy to help insulate the portfolio from rising interest rates and widening credit spreads.

But Australian 10-year yields recently approached 4 per cent, and five-year Australian bank fixed income securities can be bought at yields of close to 5 per cent. We are in the process of deploying some of that cash back into the market, and rebuilding the funds’ duration exposure, something we started doing in the fourth quarter of 2022.

The below Chart 1 highlights the differences that have emerged in yields over the past 12 months.

In addition to high-quality, investmentgrade bonds in Australia, we also like investment grade issuers in the United States where we believe investors are still being compensated for the risk of default in a recession-type scenario.

At this stage, we are avoiding noninvestment-grade credit – those issuers rated BB and below – as we feel spreads are likely not pricing in recessionary risks, therefore they carry too much risk for the credit premia on offer.

Why invest in bonds when term deposit rates are so high?

We get asked this question a lot. Term deposits may appear to be offering reasonable rates, particularly compared to what they were offering just 12 months ago, but, particularly in global markets, it is possible to find opportunities for yields that are much higher than term deposits.

Also, analysis we conducted using Reserve Bank of Australia bank data showed term deposits lag general market moves higher in rates. Therefore, if you lock into a term deposit early, you could be locked into

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Chart 1: Rising yields bring opportunities

Yield by asset classification

Continued from previous page unattractive rates for a term of up to three years or longer.

Cash should always represent an allocation in a broader investment portfolio, but there is a natural limit that needs to be set to avoid missing opportunities to earn higher income as we move through the next phase.

Looking ahead

The next few months could potentially be a sweet spot for fixed income as yields in investment-grade debt continue to rise prior to any economic slowdown.

Investors may be enticed to use this period to accumulate high-quality assets at good levels and wait for better opportunities in riskier assets.

Although eventually the downside risks to growth are likely to dominate market pricing, these may not eventuate for some time. This suggests we should embrace the good income on offer now in high-quality assets, and be flexible and prepared to firstly increase interest rate duration and later to add to riskier assets.

In our funds we see attractive opportunities to access high-quality assets with attractive yields.

At a more micro level we have been seeking out pockets of value across different regions. For example, Australian credit has lagged the rally in global credit markets and this allows us to continue adding exposure at attractive yields.

We consider the Australian banking sector to be high quality and well capitalised with a robust regulatory framework. Banks are currently issuing subordinated paper with a risk premium over cash of around 2.2 per cent a year. This can provide high-quality yield to a portfolio.

Investors may consider taking advantage of attractively priced fixed income markets over the next few months as opportunities present themselves.