Yield revival entices investors back to bonds

Investors endured a dismal 2022, as the impact of rising rates sent shockwaves through both fixed income and equity markets. As global bond markets slumped to the worst year on record, investors were left with nowhere to hide, with equities also ending the year in negative territory. In fact, this was just the fifth time in almost a century that investors suffered a simultaneous sell-off in bonds and stocks.

While last year’s bond market rout was painful, investors have renewed optimism in 2023, with the asset class offering yields not seen in more than a decade. However, after the synchronised slump for bonds and equities, there are mounting fears fixed income’s traditional role of providing downside protection in risk-off periods has been permanently upended.

On the contrary, we retain our faith in fixed income, and believe the compelling characteristics of bonds – as an all-important counterweight to equities, as well as able to offer attractive income – remain intact. Looking forward, we expect investors to increasingly allocate to fixed income in light of the asset class’s improved outlook. 2023 has already got off to a stronger start for the asset class.

The return of income

We are already witnessing signs of a sustained fixed income sentiment shift, with the enticing yield opportunity – both on an absolute level and relative to equities – powering substantial investor inflows so far this year.

With the extreme inversion of government bond yield curves, even two-year sovereign bonds from the US government are offering yields around 4%. In the credit space, global investment grade yields have risen sharply from an average 2% to 5% since the beginning of 2022, while global high yield has jumped from around 5% to 9%. Within securitised credit, an area of the market that felt the full force of last year’s sell-off, yields of 4-10% are compelling given the securities are largely investment grade quality with floating rates.

Looking across regions, the European corporate credit market shows particular promise, benefiting from attractive valuations and a somewhat more favourable growth outlook than the US or UK. Elsewhere, emerging markets are likely to once again drive global growth – led by China’s post-Covid recovery. This is constructive for emerging market debt, where credit quality in certain areas is robust and a number of central banks are well positioned to manage a potential slowdown.

Most awaited recession ever

As we move through 2023, the impact of a potential recession is clouding the investment landscape. With central banks continuing to tighten rates in response to elevated inflationary pressures, most lead indicators are pointing to an eventual slowdown – and economists are forecasting a global downturn.

Even though a recession would likely take the pressure off rising rates, it may be challenging for central banks to engineer a slowdown in inflation to the desired 2%, without triggering a larger rise in unemployment. Should a 0.5% decrease in employment spiral to 1-2%, companies would likely retrench, banks would become more reticent to lend, and demand for credit would wane – thus fuelling a deeper crisis.

However, a recessionary environment could ultimately be positive for key parts of fixed income, notably government bonds, as it would allow bond yields to reconnect to the lack of growth, creating an opportunity for potential capital gain as bond prices rise. While yields will be reset lower, the relatively steady income provided by bonds should be in demand from investors looking to de-risk.

A comfortable cushion

Irrespective of the eventual depth of the downturn, fixed income investors are in a far more favourable position today than in recent years, as higher yields offer more of a buffer against a broad bond market downturn.

In addition, the upcoming slowdown may provide an opportunity to generate strong total returns within government bonds. It is not uncommon for rate cuts to come in quick succession following the end of a hiking cycle. Here, a turn in employment figures will be a key indicator to watch.

Within corporates, it may be prudent to keep some powder dry should credit spreads widen. While today’s record corporate margins could come under pressure in the medium term, credit fundamentals are broadly resilient and default rates are expected to remain low. Volatility in the market should offer opportunities for active investors.