By Schroders
No investors have felt the economic regime shift of the past three years more keenly than those in fixed income markets. Returns have been sobering; US Treasuries have posted their worst loss since the fledgling United States ratified its constitution in 1787. However, such performance has also created opportunity.
Despite inflation being more elevated than the previous decade, yields - both real and nominal - on higher quality bonds now stand at their highest levels in 15 years. This not only makes them look cheap in absolute terms, but also relative to other asset classes, particularly equities. Additionally, with growth and inflation slowing, and most developed central banks at or near the end of their hiking cycle, historically this has been when investing in bonds has been the most rewarding.
The unprecedented bond market falls seen over the last three years can be attributed to three key factors. First, the low starting point in yields provided minimal income to offset capital losses. Secondly, major central banks’ most aggressive calendar year hiking cycle on record. Finally, the fallout from the pandemic resulted in the highest inflation in 40 years.
Challenges undoubtedly remain amid what we’ve labelled the "3D Reset”, with global trends related to the Ds of demographics, deglobalisation and decarbonisation reshaping the investment landscape. Fiscal dynamics in the US and other developed markets remain problematic, while high inflation is set to linger, and geopolitical tensions add another layer of uncertainty.
But the disappointing returns of the last three years are now in the history books and as we start a new chapter, we must shift our focus towards the opportunities that lie ahead. In terms of valuations, both in an absolute sense and relative to other asset classes, bonds screen as cheaply as they have in the last decade and in the top quartile in terms of their attractiveness over the last 20 years. That doesn’t mean a rally is necessarily imminent, but the higher yields do offer a significant cushion in terms of income to offset any further price declines.
Global: 3D Reset will lead to deficits, debt, and defaults.
Julien Houdain, Head of Global Unconstrained Fixed Income: “The market has fully embraced the higher-for-longer narrative as inflation challenges persist. But with interest rates now peaking, what’s going to drive markets in 2024?
We think the 3Ds of decarbonisation, deglobalisation and demographics are likely to lead to three more Ds with major consequences for fixed income investing: deficits, debt and defaults. Although this doesn’t sound particularly positive for the bond markets, we see some compelling investment opportunities ahead.”
”I’m not worried about the deficit. It’s big enough to take care of itself”
Unlike Ronald Reagan, as bond investors we do worry about the size of government budget deficits, which are large for this stage of the economic cycle. And the market is beginning to take notice. Nowhere does this have greater significance than in the US, where the deficit is beyond that seen at any time in the pre-pandemic era.
Worryingly there seems to be few signs of curtailment any time soon. While pandemic support measures have now all but ended, longer-term ‘green’ subsidies, including those offered by the Inflation Reduction Act, (which is helping to fund the decarbonisation effort) have now taken up the fiscal baton.
Meanwhile, reshoring in the form of the CHIPS Act, motivated by a protection of national interests (part of a broader deglobalisation trend), and the requirement to support an aging demographic are adding fuel to the fiscal fire. The problem being that financing this level of debt is getting significantly more expensive.
All this points to structurally higher bond yields, but also to a greater level of market divergence as regional fiscal trends differ. This presents interesting cross-market opportunities. Let’s take the eurozone, for example. Unlike the US, the fiscal narrative here is one of consolidation which warrants a preference for European bond exposure over the US.
”Creditors have better memories than debtors”
Fiscal management is intrinsically linked to our second ‘D’ - debt dynamics. Transitioning to a new era where financing costs are higher, is likely to perpetuate a vicious cycle, adding to the stock of debt in the years to come.
After years of price-insensitive buyers (i.e., central banks) dominating demand for debt, they are retreating because of quantitative tightening. This means greater reliance upon price-sensitive buyers of debt, who expect greater compensation for holding a bond over a longer period (higher “term premia”).
This should lead to a steepening of yield curves, meaning a growing difference between long-term and short-term bond yields. Indeed, we see value in strategies that benefit from yield curve steepening across a number of markets.
More broadly, the higher coupons generated not only provide a cushion against capital losses, but also offer a genuine alternative to other income-generating asset classes (including equities) for the first time in many years.
The Big ‘D’: default
Default is the ultimate risk to bond investors. For cyclical assets, the macro environment is likely to have the most relevance. We currently assign a high probability to an economic ‘soft landing’, but it’s difficult to ignore the warning signs around a potential ‘hard landing’ as tighter financial conditions bite.
With central banks all but finished raising interest rates, the start of a rate cutting cycle in 2024, would be a real support for bonds. Corporate default rates will likely rise, although with balance sheets relatively robust, we are not expecting them to spike significantly.
Nevertheless, the transition to higher funding costs may be much faster in some economies compared to others. The pass-through from higher interest rates is felt much more quickly in Europe, where bank lending is far more prevalent than capital market funding, which is favoured in the US.
As a result, we expect there to be greater market dispersion, not just on a regional basis, but at an issuer level too, as investors will want to be compensated for allocating to more levered corporates. This creates opportunities to generate outperformance from careful bond selection.
Although the higher income offered by certain cyclical assets do provide a cushion against losses, given the risks around a potentially sharper slowdown, we prefer to play it relatively safe. A preference for investment grade (IG) over high yield, with an allocation to covered bonds, government related and securitised debt remaining a favoured high quality, lower beta way of adding yield to a portfolio.
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