Heading into 2023 the consensus was that this would be the year of the bond. It hasn’t quite turned out that way.
Inflation has remained persistently sticky, central banks have continued to hike interest rates and economies have been more resilient than anticipated. Total bond returns, while certainly far superior to 2022, have disappointed.
But, while more short-term volatility is likely as markets react to mixed economic news, it is worth zooming out and taking stock of the situation more broadly. In our view, in a very short period of time, the world has totally changed and that has ushered in a new regime for bonds that will offer investors exciting opportunities in the years to come.
Are we there yet?
Central banks have hiked aggressively in this cycle and are now reiterating their higher for longer stance, leaving policy rates unchanged in the latest meetings. While the peak in rates may have seemed elusive, we feel the cumulative effect of quickly increasing rates to this level – and then a subsequent pausing – means we believe we are at or near peak rates.
In the US, the treasury market has priced, over the past few months, a near perfect economic landing and many are now discounting a recession or hard landing. We do not rule out any of these scenarios, however, after 500 basis points (bps) of rate hikes in record time, in our view the probability of a perfect economic landing is fairly low. We are therefore thinking about outcomes the market is not pricing in and what the opportunities are.
Interestingly, there appears to be a wide range of expected outcomes for interest rates, particularly in the US. We have seen some strategists suggest rates could fall to 1%; other commentators are forecasting more like 7%. That’s quite a variation.
In our view, central bankers will work hard to get inflation down to 2%, but they might tolerate a slightly higher level if it avoids a nasty recession; on the other hand, they will need to avoid elevated inflation. A difficult task, which suggests to us higher rates, which is increasingly priced in.
Yields
Given the regime shift we have seen – from the yield-crushing decade of quantitative easing and low inflation to, within three years, 2007-era yields and very high inflation – it is no surprise that some dramatic statistics have emerged.
One particularly staggering one is that the drawdown in long-dated Treasuries has now surpassed the drawdown experienced by the S&P 500 during the global financial crisis. Given today’s environment, will this seem an obviously compelling investment opportunity in the future?
Recently we purchased some long-dated Treasuries with a yield of nearly 5% – itself attractive – at 50 cents in the dollar, half their par value. Valuations in some areas have simply become incredibly attractive.
What lower valuations signal is that bonds can now, for the first time in years, hedge against risk assets. They offer enough yield to justify their place in a portfolio and they should perform well when rates start to fall, a recession begins and/or equities start to come down. Faith in the 60/40 allocation model is gradually being restored.
Moreover, the risks of owning bonds have, in our view, become asymmetric. For a given change in yield – up or down – total returns are greater when yields fall, than the loss experienced when yields rise. An attractive risk/reward in our view. We may not be able to call the bottom of the market, but we are certainly being paid to wait for it.
Positioning for the new regime
We are carrying more duration than we have done for a while (around 6.5 years) in line with a view that the markets are cheap and will benefit from a move towards lower yields. Calling the high in yield in volatile markets is very difficult. We think it’s better to be positioned in this way and make an active decision to be patient rather than potentially miss out if and when bonds start to rally.
We like using different duration currency curves, with US treasury our starting point, but we also use core Europe and UK Gilts. Having neutralised our UK Gilt duration over the summer, UK Gilts are now starting to look more interesting and could be a way to benefit from the move lower in global yields.
We are also positioning for a steepening of the yield curve, which has been inverted for some time now. When markets rally, rate-sensitive short-dated bonds should outperform long-dated bonds (their yields will fall further) and this trend should, we believe, last multiple years – particularly if we are entering a weaker economic period necessitating rate cuts.
Ultimately, we do expect there to be a recession, but invariably it comes down to timeframe. Europe may already be in one. In the US, there are no obvious signs as yet, but rates at their current level – 5.25%-5.5% – are restrictive enough to cause a downturn. The Fed will want to see unemployment data and wage inflation come down before cutting rates.
If we do see a weakening economy, default rates will pick up and the market will punish issuers it perceives as having excessive leverage. Those which borrowed long and have maintained strong balance sheets will, on the other hand, be rewarded.
This dispersion will increase as conditions worsen, providing opportunities for investors paying attention to credit fundamentals. No longer is the difference in yield between a good company and a bad one negligible.
The bond market is still trying to find a new anchor after the upheaval of the past few years. Central banks have moved from hoovering up bonds, irrespective of price, to selling them. Rates in the US and UK have gone from zero to more than 5%. These are tectonic shifts that were always going to cause financial and economic pain.
We are now in a higher-for-longer world, but it’s one that will present plenty of opportunities for those able to take them.
Nick Hayes is head of total return & fixed income asset allocation at AXA IM. The views expressed above should not be taken as investment advice.