The bond market is now offering equity-like yields not seen since before the global financial crisis, possibly making fixed income one of the most attractive asset classes for investors. It follows one of the worst years on record in 2022, when aggressive rate hikes by central banks prompted a decline in the price of existing bonds, generating heavily negative returns.
In a roundtable hosted by Investment Magazine and global investment manager T. Rowe Price, participants representing super funds, research houses and asset consultants discussed whether bonds were back in favour, the outlook for inflation and interest rates, implications for other segments in fixed income such as private credit and how investors are incorporating ESG risks in valuations.
Benchmark 10-year US Treasury yields topped 5 per cent in late October on growing expectations the US Federal Reserve would keep interest rates higher for longer. Yields have since slipped to 4.6 per cent. A rising yield indicates falling demand for safe government bonds with investors preferring higher-risk, higher-reward investments.
“The conflict there is that the central banks’ impatience to see the effects of their monetary tightening is actually leading them to make a mistake. It’s leading them to tighten by too much,” said Quentin Fitzsimmons, senior portfolio manager at T. Rowe Price.
Fitzsimmons, who is part of T. Rowe Price’s US$169 billion fixed income division, said investors are now trying to “time the top” of the interest rate cycle, which has been increasing uncertainty and volatility in the markets.
Inflation Uncertainty
The revival in yields comes after years of central bank stimulus during COVID, which pumped liquidity into the financial system, brought yields down to historically unseen levels and encouraged risk-taking by investors. When post-COVID inflation growth pushed central banks into a corner vis-a-vis their mandates of keeping inflation low, they were forced into a very aggressive response to unwind the stimulus.
Fitzsimmons said the stickiness of inflation has been clearly worrying central bankers because this is the first proper test of their inflation mandates.
The US Federal Reserve has signalled borrowing costs may need to stay higher for longer as the central bank looks to ease inflation back to its 2 per cent goal. The Reserve Bank of Australia this month lifted rates by a quarter percentage point after a four-month gap, worried by the slowness in reaching its inflation target range of 2-3 per cent.
Reasons for inflation remaining high include factors like tight labour markets, upward pressure for better compensation as workers suffer falling real living standards, and expensive decisions to change the way we source our energy. Geopolitical tensions and choke points around energy supply have also played a part.
Fitzsimmons termed it the fire on which central banks poured a load of liquidity through the COVID stimulus process, stoking prospects for inflation to remain at higher levels and testing their inflation mandates.
“The real risk is that in their intent to achieve those goals, they actually drive us into very significant recessions, which ironically, might be depression,” he said.
“So we may go from inflationary boom to deflationary bust.”
There is now a risk of a much sharper contraction, which will end the hiking cycle and even prompt central banks to consider cutting interest rates. However, governments have continued to remain fiscally reckless, he said, and their financial position and deficit projections are much worse than they have been for years.
Sonia Baillie, head of income assets at the $160 billion Aware Super, believes that while bonds have turned more attractive because of higher yields, the market is still uncertain about inflation.
“I think really we have to go back to what’s happening with inflation,” she said.
“Why are we here? And have we have we won the battle yet?”
While central banks had started hiking rates because of so-called transitory supply shocks that sparked inflation, they are now starting to consider more structurally higher inflation because of factors like deglobalisation, friend-shoring, geopolitics as well as the energy transition.
“These are long term structural changes that, we’re all still trying to understand,” Baillie said.
“Certainly inflation is diminishing and it’s moving in the right direction. And we know that policy works with long and variable lags.”
Dealing with volatility
While it’s still uncertain if rates have peaked, consensus is emerging that the hiking cycle is entering the later stages, given that monetary policy settings operate with quite a lag, said Iain McMahon, head of bonds, currency and derivatives at Frontier Advisors.
Markets are sanguine on the default outlook, betting on a more prolonged, softer landing type scenario with elevated defaults over a period, rather than a one-off major default event as in the GFC, McMahon said.
That would mean active management and security selection will become increasingly important.
It is a view shared by Evergreen Consultants director Angela Ashton, who expects diversification into different asset classes to become more important because of the varying market dynamics.
The traditional 60/40 strategy – which combines growth from stocks with the safety from government bonds – has already been under pressure since the pandemic. It was generally believed that equities and bonds move inversely, providing the balance when one of these markets performs poorly.
“We’ve got to see a few people fail, and I suspect we will. Hopefully, that will raise everybody’s eyebrows and they’ll all sort of work out what it actually is.” – Angela Ashton, Evergreen Consultants
However, the post-pandemic spike in inflation and the resulting aggressive rate hikes by central banks have thumped both stocks and bonds in tandem, with this dynamic likely to persist if rates are kept higher for longer.
Ashton said while rate hikes may be nearing an end, there is still a lot of volatility in store for the bond market because the fiscal position of many governments has made the whole bond demand-supply equation much more difficult to understand.
“It’s definitely more complex than just when do rate hikes stop,” she said.
“Having said that, over the medium-term bonds do represent probably one of the better areas of portfolios, in terms of opportunity. I think it’s going to be a rough journey, though, for a little while.”
Private markets remain attractive, but risky
Despite bonds, or duration, coming back on the radar, we aren’t looking to make meaningful changes to our long-term fixed income asset allocation. Baillie said private credit will continue to play a role in Aware Super’s credit income allocation.
This will partly be led by the fund’s return targets, but also because a key factor in this cycle is the increasing need for active management due to the likely dispersion in credit at this stage of the cycle.
“If you look to the past decade, the response to crisis had been more liquidity,” Baillie said.
“Now I think we’re sort of back into a cycle where stock selection, sector allocation, those things are actually going to be stronger sources of return.
“And so we still have high conviction in the managers that we work with in terms of the way that they’re constructing their portfolios and the way that they’re managing risk there.”
While the private segment remains popular for allocations, market players fear the current high yields may be making it too attractive for investors and spurring some to ignore the risks.
Evergreen’s Ashton said some investors actually question the need to allocate to safer bonds given the current high returns on private credit, without considering the lower grade of that portfolio.
“I think a lot of people are buying them without any understanding at all of the risk, and the illiquidity actually plays to the idea that it is safer somehow than less safe,” she said.
Mercer investment consultant Andrew Stewart similarly said conversations with clients have largely revolved around credit risks and potential for defaults in the next calendar year. Clients, though, have been slow in recognising the risks of defaults given the increase in private markets allocations.
“What is probably important from our perspective is making sure that your credit risk is balanced out.”
He said concerns have centred around some positions in high-yield sectors such as property, where it is still uncertain what impact a sector-wide shakeout might have.
“We do have some concerns around investment grade credit even within Australia,” he said.
“Obviously, there is heavy exposure to the financials and we really haven’t seen the mortgage cliff play out.
“Whether that really does shake out or is it getting help from quite a lot of immigration remains to be seen, but we are taking more of a cautionary approach in terms of outlook.”
Adapting to market dynamics
Isrin Khor, fixed income sector manager at research firm Lonsec, pointed out that a lot of money has been pouring into investment-grade credit, even though it doesn’t seem that attractive from a valuation point of view. The higher quality debt would be well-placed, however, in the event of a recession.
“Bonds are back in some ways, in the sense that we’ve got high starting yields now,” she said.
“So any rate hikes going forward might not have a significant impact like they had in 2022.”
Another important consideration for investors has been the evolution of the environmental social governance (ESG) framework.
“We do see fixed income managers now incorporating ESG integration in their process or ESG risk as part of their valuation or when they consider security selection for non-sustainability products, too,” Khor said.
Cassandra Crowe, the ANZ head of consultant relations for T. Rowe Price, agreed that investors have been increasingly interested in global active fixed income solutions given the market dynamics. Another theme that has resonated with investors has been renewed interest in the global aggregate fixed income strategy – which typically invests in treasury, corporate and securitised fixed-rate bonds from both developed and emerging markets issuers – for some funds tracking to the Your Future, Your Super benchmark, Crowe said.
Crowe added that the firm has seen strong interest in ESG across the spectrum, from ESG integration, which is expected by investors, all the way to impact investing strategies where you have an explicit impact objective, based on the client’s needs.
T. Rowe Price holds an extensive proprietary database which rates the entire security offering in the global aggregate. It has a traffic light system, which then factors in the environment, social and governance selection.
“We understand that we are providers of investment advice, we’re custodians for our clients’ assets, it’s not our job to judge what is correct or not. It’s our job to understand the client’s requirements; the client’s target; the client’s tolerance, and to make sure that we can construct a strategy which meets those needs,” Fitzsimmons said.
Bond investors generally employ a strategy focused on buying bonds with a small duration when they are very uncertain about interest rates and want to reduce their risk.
Frontier’s McMahon has also been keen on global private debt, typically with both US and European representation. He also considers liquid emerging market debt quite attractive too.
“I think certainly their monetary policy has been a lot more proactive and if you are selective, there’s certainly a very positive real yield story to be played in Brazil, in Mexico, in Colombia,” he said.
“A lot of those have got commodity-centric tailwinds as well.”
