Weekly update – Spoilt for choice
This week’s update, written by Bob Tannahill, originally appeared in Portfolio Adviser. To read the original article, please click here.
For more than a decade after the 2008 global financial crisis, a low interest rate environment considerably narrowed the options available to bond investors, with one or two percent returns becoming an accepted norm. At the peak of this effect during the Covid pandemic Bloomberg estimated that $18.4 trillion of bonds globally offered negative yields1. However, as central banks around the world have tried to tame rampant inflation, the tables have turned. Investors are now spoilt for choice on income assets, with plenty of attractive entry points for those looking to return to the asset class.
To put last year in a historical context, for a number of bond markets, such as US corporate bonds, 2022 was the worst calendar year on record and significantly worse than previous shocks, such as 1974. Take one of the longer standing indices such as the Bloomberg US Corporate Bond Index as an example. This index fell -15.8% in 2022, materially worse than the previous "boogeyman" year of 1974 (-5.9%).
This combination of a low-rate environment followed by a big shift has been a painful process for bond investors. We have endured an extended period of low returns followed by big capital losses in 2022. Despite a short-lived rebound following on from October last year, when US core inflation rolled over, the market shocks continued into 2023, ranging from Chinese spy balloons to a US banking crisis and not to mention a roster of worrying economic indicators in the UK, including inflation and wages. These market shocks have ultimately conspired to keep markets soft and have stopped capital values rising as might have been expected.
Despite a rise in yields following central bank interest rate rises, there seems to be a disconnect in the bond market today. Sentiment is poor and confidence remains subdued, while current valuations are some of the best the market has seen in many years. For example, as I write there are AAA rated Sterling bonds on offer that promise investors returns in excess of 5% per annum for the next three years or so. That is an offer we could only have dreamed of just a few years ago. Investors are now presented with a rare chance to pick a selection of assets with relatively low risks and respectable returns.
Many investors have piled into cash, given rising interest rates, and while instruments such as money market funds might look attractive now, the landscape may change in the next year or two. Although the Bank of England still faces a reckoning when it comes to controlling inflation, some of these inflationary pressures seem to be easing in parts of the economy, and you have to question for how long the economy can withstand higher interest rates. When rates are eventually cut, I think you may find investors wishing they had taken the window of opportunity to lock into some of those higher rates for longer.
When it comes to how we are navigating the market for our clients, we’re focused on those areas that we see as having really attractive total return potential over the next three to five years, although how these assets will fare for the next six to 12 months is, as always, uncertain. Recent examples include private debt via investment trusts such as Sequoia Economic Infrastructure Income Fund, short-dated high-quality bonds such as UK Gilts or highly rated supranational bonds like the European Investment Bank. Or, at the margins, more exotic assets such as insurance linked securities via funds such as the GAM Star Cat Bond Fund.
While future returns on bond funds are less clear cut than on simple assets like cash in the bank, the yield to maturity is a good proxy for medium-term investors. Over the years I have seen a number of studies from firms like PIMCO that all reach the same conclusion – that your purchase yield is the single best guide to forward looking bond returns. To put a number on this, if you take a conservative Sterling bond fund like Twentyfour's Corporate Bond Fund, as at the end of July it had a yield to maturity of 6.7%, which compares favourably to cash even if rates stay around current levels for now.
On the horizon
Where interest rates eventually settle for the next few years, only time will tell. There are massive structural forces, such as demographics and productivity, that are weighing down on interest rates in the longer term as the IMF noted2 recently. While the days of near zero rates are likely behind us, there are also many unknowns, such as financing climate change mitigation and whether the world regionalises which are yet to play out and will influence how the market develops.
Whichever way this goes in the longer term, investors seeking simple and cost-effective returns are blessed with a huge array of options today. We will continue to see market volatility in the short term, which is something that investors must contend with, but a good bond portfolio should do well over a three-to-five-year period and investors should look to the yields those bonds can be purchased on today for reassurance that they will ultimately be compensated for that volatility.