Putting the income back into fixed income: the return of bonds as an investable asset class
After a decade or more with yields hovering around zero in many developed markets and falling into negative territory in countries including Germany and Japan, bonds are back.
Rising inflation has triggered tighter monetary policy around the globe, pushing yields up. Aggressive action by central banks, led by the US Federal Reserve has “put the income back into fixed income, says Anne Walsh, Chief Investment Officer, Guggenheim Partners Investment Management.
Investors are responding: the US, some $140 billion has rotated out of equities – for so long, the default choice for retail and institutional investors – in the year to May. Some of it has found its way into long-dated bonds. But the eye-popping fact has been a $585 billion inflow into money market funds over the same period, as investors have taken advantage of higher returns available at the short end of the (currently inverted) yield curve. No doubt, some of this represents the deployment of cash savings accumulated during the Covid pandemic.
Most economists and analysts see this as a long-term development. The enormous costs of the energy transition, combined with reshoring supply chains and ‘derisking’ the key US-China trade relationship all point to structurally higher prices in the future. And since the monetary authorities are determined to regain control over inflation, rates are likely to stay elevated for longer than initially expected in most major economies – with China, which appears to be flirting with wholesale price deflation, a notable exception.
Restoring the status
That is positive for yields.
We have undoubtedly changed the regime for the absolute level of interest rates”, states Eric Bertrand, Chief Investment Officer, Ofi Invest Asset Management, thereby restoring the status of the money market and investment grade assets, two asset classes that had markedly lost their appeal in the previous decade. The asset allocations of major investors will therefore inevitably change.
As the battle against inflation continues, it is important to assess whether investors are getting a good deal in fixed income, or whether real yields are still negative?
Investors are being compensated for risk at current yield and spread levels, argues Ms Walsh, pointing to the fact that US inflation is expected to fall to close to 3% by the end of the year, compared to yields of 5-8% currently available on investment-grade securities.
She notes, however, that investors should be – and are being – selective. Core and core-plus strategies have led the way in terms of attracting new money, while non-traditional, high-yield, bank-loan and short duration funds are still experiencing outflows.
Guggenheim believes investment-grade structured credit looks particularly attractive right now, on an absolute and a relative basis. The shorter average life profile of structured credit can offer less mark-to-market volatility and has contributed to outperformance relative to corporate credit indices in 2023. Investable yields in structured credit remain significantly higher than similarly rated investment grade corporate credit.
And as inflation gradually comes under control, the market will start to anticipate rate cuts in 2024 – again, with the US likely to lead, followed at some distance by the European Union and the UK (while Japan has not yet begun to tighten). That could provide a catalyst for bond outperformance over both equities and cash as investors seek to lock in yields and spreads while they are still at currently elevated levels.
Return to normality
It is also a new paradigm for issuers of bonds and fixed-rate products, says Felix Orsini, Global Head of Debt Capital Markets, Societe Generale – or rather, a return to the market environment that prevailed a generation ago.
After several years when bond issuance boomed, reaching a global record of €500 billion in 2020, last year was a brutal year of ‘transition’ and risk-averse behaviour on the part of investors, with volumes plunging to just €270 billion.
So far, this year, issuance is recovering to more normal levels. Central banks are no longer buyers of last (and sometimes, first) resort and institutional investors are still being selective. So, markets are not as deep as they were, with a typical bond 2-3 times subscribed rather than 5-6 times, as at a peak.
But this is arguably a healthier market, says Mr Orsini, one where the fundamentals of supply and demand, creditworthiness and cash generation are reasserting themselves.
Increasingly, of course, issuers are also being assessed on their Sustainability and ESG strategies, with this section of the fixed income universe doubling virtually every year between 2018 and 2021 – though growth here is also normalising as the market matures.
With volatility returning to historic levels – Chicago’s VIX index has more than halved since October 2022 – we are “out of the fog” of last year, argues Mr Orsini. Looking ahead, issuers will need to offer higher yields to attract attention and, ultimately, funds. But creditworthy names with good stories to tell will have no problems issuing bonds, while offering investors positive returns – a fair bargain that should seal the re-emergence of fixed income as an investable asset class.