Fixed income markets are moving out of the doldrums encouraged by the medium-term prospect of declining interest rates. Despite persistent macro-economic challenges, a new golden age could loom for bonds, one CIO argues. Investment officers and fixed income strategists that spoke to Investment Officer agree, but all underline the need to be picky.
Being selective is regarded as a critical factor for 2024 bond investments. Which part of the yield curve to aim for? Which emerging markets to include? Which type of corporate debt? But the central theme now is clear across this asset class: higher interest rates have restored yields while inflation has peaked. It’s a change with medium-to-long term appeal.
Bonds better than stocks
To begin with, investors should not overspend energy on picking stocks for the equity component of their portfolios, said Nicola Mai, London-based sovereign credit analyst at California-headquartered Pimco, a 1,700 billion dollar global investment house well known for its fixed income expertise.
“Fixed income is much more attractive here than equities,” Mai said. “Partly because fixed income is senior in the capital structure, meaning that if there is a default, or a failure, credit is the senior. And you know, when you get into the fixed income space these days, you get equity-like returns, given the high levels of yields but with most likely lower volatility.”
Calls on the return of the bond market have emerged several times in recent years, all encouraged by a belief that central bank interest rates were near their peaks. “Bonds are back,” Paris-based Amundi, Europe’s biggest asset manager, shouted in September 2022, only to be caught off-guard by persistent inflation and additional central bank hikes in 2023.
Unlike a year ago, the calls now are carried widely by a broad spectrum of fixed income specialists.
‘A golden era for bonds’
Unlike a year ago, enthusiasm is now widely shared. «Despite a challenging macro environment, we believe we are entering a golden era for bonds,» said Gregory Peters, co-chief investment officer at PGIM Fixed Income.
At private bank Quintet in Luxembourg, head of macro research Nicolas Sopel sees three catalysts that make fixed income attractive: valuation, the economic slowdown and central banks cutting rates. “We’ve added a little bit of duration, we’ve added a bit of Treasuries in the US. Government bonds will offer you a cushion in the case of a deeper than expected slowdown.”
“After a very difficult 2022 and a rollercoaster in 2023 for fixed income markets, we believe that the worst is now behind us and that 2024 will be very favourable for bonds in general and for Emerging Market credit in particular,” said Andranik Safaryan, debt portfolio manager at Mainfirst. ”Fixed income should be the asset class of choice in a late-cycle scenario.”
Pimco’s Mai said the good times of fixed income are illustrated by the fact that markets are seeing the highest levels in yields in 10 to 15 years. “We know that when yields are high, returns on fixed income tend to be high,” he said, adding that the prospect of an economic slowdown means rates are at their peak.
What’s more, fixed income investments can be regarded as a hedge against a deeper-than-expected economic downturn. “Fixed income gives you hedging properties, Meaning, obviously, if you have a deep downturn, then duration-interest rate risk will outperform in terms of returns.”
Cash holdings, in recent years, have been seen as king in recent years, which may not remain the case, said Mai. “The curve is still inverted, and you got the highest yields at the very front end of the curve. These cash shields are fleeting. They’re here today. They’re probably not going to be here in a year’s time, in two years time. So it makes some sense to us to lock in these yields by taking some duration risk in portfolios, meaning buying bonds, which are not cash, but which are further along the curve.”
Belly of the curve
For that reason, Pimco likes the belly of the curve, the part of the yield curve that reflects the projected returns for bonds that mature in five to ten years. The firm stays clear of the shorter end, which has been lifted also by shorter-term market sentiment and talk of upcoming central bank rate cuts, and of the longer end, which faces “quite challenging fiscal dynamics.”
“We favor less the very front end of the curve and the very long end of the curve,” Mai said. “The very front end because there’s really a lot of cuts priced in for the near term. The very long end because there is a so-called term premium, partly because of fiscal concerns and partly because of less QE appetite by the central banks.”
At DWS, Europe’s second-biggest asset manager, head of rates and fixed income Emea Oliver Eichmann, urges investors to consider euro investment grade corporates. “An environment of let’s say moderate or slow growth and central banks that are cutting rates is typically a very positive one for corporate credit. In addition, valuations are looking sound and compelling for investors.”
Eichmann’s DWS recommends bank bonds over non-financial corporates. “In a historical context, the spread of bank bonds or financials vs non-financials are still relatively high. There is a huge pick-up in this big spectrum that might diminish somewhat in the future.”
Pimco’s Mai explained that, while corporate bonds, like sovereigns, are also attractive because of their duration component, the spread component actually should make investors cautious when it comes to corporate debt.
Credit spreads tight
“Credit spreads are relatively tight from a historical perspective. We don’t think the spread gives you great compensation for the economic risks that we see over the cyclical horizon. So we are generally cautious on corporate credit, given our economic expectations.”
Mai said Pimco prefers to be “up in quality” in the investment-grade corporate space. “We also see a lot of opportunities in the structure. credit markets, like securitized assets, agency mortgages in the US are, which are basically guaranteed by the US government, are very attractive here.
“You can get a triple-A type risk, giving you very interesting yields where you don’t have to go down in quality. We really stress the importance of staying in high-quality, liquidity-resilient type assets when it comes to credit.”
Luxembourg-headquartered fund manager Mainfirst - some 5 billion euro in assets under management - is clearly upbeat on corporate emerging markets bonds. Younger populations, the presence of desirable commodities and a relatively weak dollar will drive sentiment and returns on emerging market assets in 2024, said Safaryan.
‘Stars aligned for EM debt’
“We believe that the stars are aligned for Emerging Market credit to shine in 2024,” he wrote in a note to investors. “Idiosyncratic stories such as China’s real estate crisis and the conflict in Ukraine remain unsolved, but the universe has been through two years of cleansing and most names have already defaulted and bottomed out.”
At Pimco, sovereign debt specialist Mai underlined also sees value in emerging markets, but said investors here also need to be selective. “We like duration in countries where the central banks moved early as they were more orthodox in the hiking cycle. Brazil and Mexico for example. When it was time to raise rates, they raised well ahead of the Fed, and they now can cut rates meaningfully going forward. We think these countries can reap the benefits of their orthodox.”
“In other countries that were not as orthodox like Poland or Turkey, we will be cautious on interest rate risk,“ he said.
This fixed income outlook is the third of four 2024 outlooks published by Investment Officer. On Wednesday 13 December, the CIOs of Europe’s three largest asset managers gave their views. The equity outlook was published on Tuesday 19 December. In the coming days, we take a closer look at the outlooks for private markets.