As inflation has started to normalise, many market observers have started to find bond markets attractive again. Yields have risen to their highest levels in over a decade. Corporate debt has recovered, making bond investors comfortable after years of bad returns.
During the Covid pandemic, expansionary monetary policy in the developed world led to a large injection of liquidity into the financial system, which in turn led to an increase in consumer spending as the situation began to normalise, explained Carlo Putti, the investment director at M&G Investments. «This led to bottlenecks in supply chains and the start of problems with rising inflation,» he said.
However, liquidity has declined sharply in recent quarters, which should gradually lead to a stabilisation of inflation, Putti noted. Good news is also the economic situation, with households and companies in a good financial position with significant reserves. «Compared to 2008, a large proportion of mortgages in the United States are at fixed rates, making the US economy much more resilient.»
Recovery of bond yields
The significant recovery of yields in bond markets, and more specifically in the corporate debt segment, Putti said in pointing to a third optimistic factor. «Yields are back to their highest levels in more than a decade and risks are now much better integrated into market expectations,» he says. As bond investors, the current situation has rarely been so comfortable.»
M&G Investment’s flagship product in the bond markets is the M&G (Lux) Optimal Income fund, with nearly 10 billion euros of assets under management. Morningstar considers this product a conservative mixed fund, as the manager has the option to take a 20% exposure to equity markets. In practice, that exposure has rarely exceeded 5% of assets over the past 10 years. «We have equity exposure when equity markets are particularly attractive compared to bonds, which is currently not the case at all,» Putti explained.
Higher duration
After a 12% drop in returns in 2022, the fund is now in much better shape with a 4% rise since early 2023. «We increased the duration of the portfolio from 2.5 to 6 years, which we consider a neutral level for our strategy. The duration is currently at its highest level since the 2008-2009 crisis,» Putti noted.
M&G (Lux) Optimal Income is currently invested almost equally in government bonds, investment grade corporate bonds and high yield. «Within investment grade, we mainly prefer bank debt. While many investors continue to shun this asset class (resulting in higher yields), we believe banking institutions are clearly not as vulnerable as they were in 2008 and their profitability will be supported by rising interest rates,” Putti said.
The fund’s positioning has changed significantly since the strategy was launched in 2006, he explained. «After starting as a relatively normal bond product, the fund became almost a high yield fund (average rating BB) in 2012, before we gradually reduced the risk, with an A rating for the portfolio between 2019 and 2021.
European debt
In recent months, positioning has become much more aggressive again, with the average rating falling back to BBB. «We are now much more comfortable including credit and duration risk in the portfolio again. We will see the default rate rise,» said Putti, «but the market seems to be assuming a rate typical of a deep recession, which seems far too aggressive to us. Especially in the investment grade segment (BBB and above), the expected default rate is particularly high compared to the worst default rate in the past.
Sovereign debt positioning is usually driven by the central bank adopting the most restrictive strategy, he said. «Currently, it is still mainly focused on US debt, with maturities between 5 and 10 years. However, we have started to reduce our positions in US government bonds to get more exposure to European (and UK) debt, as the ECB is now the most determined monetary institution to raise interest rates,» especially on long maturities in France, Spain and Italy.
A version of this article originally was published on Investment Officer Belgium.
Related article on Investment Officer Luxembourg:
- BeeBonds offers €3 mln bond on Bettembourg project
- iShares: bond ETF market can grow to $5,000 billion
- EIB issues blockchain-backed bond under Luxembourg law