Diversify and conquer, the role of fixed interest

  • Government Bond yields are the most attractive they’ve been in 15 years with the US 10 Year Treasury note yielding north of 4.5%.
  • An imminent interest rate cutting cycle provides significant potential for capital appreciation – the IA Corporate Bond sector rallied 7.9% in Q4 2023 on rate cut hopes.
  • Whilst 2022 saw both stocks and bonds down for only the third time in 100 years, negative correlation will quickly return in the unlikely event of a hard landing, providing downside protection to portfolios.

Safe to say, it has been a very long time since investors had a good reason to get excited about bonds. In the recent era of low interest rates, fixed interest has done little more than drag on a traditional multi-asset portfolio. In US Dollar terms, UK Gilts have returned -2.6% annualised over the last decade, Eurozone Government bonds, -1.9% and Japanese Government bonds -3.8%. US Treasuries at least made a positive return, 0.8% annualised over the last 10 years, but that of course pales in comparison to US Equities’ 13.1% p.a. over the same period.

The next decade is different

It gives me pause to contradict Sir John Templeton, one of the greatest stock pickers of all time, who famously said ‘the four most dangerous words in investing are: ‘this time it’s different’’, however, the opportunity set right now within fixed interest is meaningfully compelling, broadly for two key reasons:

1. Starting yields are very attractive. As the below chart shows, 10-year government bond yields are at their highest level in over a decade. Not only does this mean you can get a 10 Year US Treasury yielding north of 4.5% or a 10 Year UK Gilt at about 4.3% but these are relatively low-risk investments making the risk-adjusted returns that much more attractive.

Source: JPM Guide to the Markets (Fixed income), 31 March 2024

2. Risks of capital erosion have almost faded away. As inflation proves stickier, bond yields move higher as expectations of central banks cutting interest rates are pushed back, lowering bond prices. With expectations already brought down from 6 to 2 rate cuts in the US and now pushed back from June to September, a lot of the short-term pain in bond values has already been felt. With the central banks all now talking about rate cuts, it seems inevitable we’ll see them in 2024, particularly if they want to avoid tipping global economies into a deep recession. Furthermore, the yield mentioned earlier acts as a healthy cushion against any further rate rises and yields would have to rise by c. 45 bps for an investor to see a negative return on government bonds over the next 12 months.

Source: JPM Guide to the Markets (Fixed income), 31 March 2024

Investment grade bonds

Moving up the risk scale from developed market government bonds, investment grade (IG) credit also looks very attractive. With a yield of 5.3%, it is estimated that yields would have to rise by 200 bps (2%) for an investor to actually lose money over a 12-month period. Q4 2023 served as a glimpse into the potential of fixed interest over the next couple of years. The IA Corporate Bond sector rallied 7.9% in the quarter following the Fed’s comments around potential interest rate cuts in Spring 2024 – the strongest quarterly performance in over a decade for the sector – and we are optimistic there is more to come.

The caveat is that credit spreads are exceptionally tight with the US IG credit spread contracting again in the first quarter of this year and now at just 85 bps – this makes it quite expensive.

So, how are we positioned at Bowmore?

With the yield curve inverted, you can find very attractive yields without having to take on too much duration risk i.e. limiting our sensitivity to any short-term interest rate volatility. Therefore, we like short duration investment grade credit and are actively looking at increasing this exposure further on a global mandate. As our view is that interest rates will come down this year, we will be proactively tweaking our bond exposure to maximise returns for clients as this plays out. We prefer UK gilts to US treasuries at present as we think there is a greater risk of longer lasting inflation in the US – particularly with the inflationary pressures that an election brings and current levels of spending/tax cuts being campaigned upon.

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