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Why positive news may be on the horizon for fixed income

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5 minute read

Although fixed income assets faced immense pressure last year due to high inflation and interest rates, the outlook for this asset class is starting to look more positive.

To say that 2022 was a difficult year for fixed income would be a “gross understatement”, according to UBS Asset Management’s head of fixed income, Charlotte Baenninger.

“With central banks across developed economies responding to inflation reaching 40-year highs, bonds have repriced significantly, causing the largest losses across the fixed income spectrum in many years,” she said. 

But Stephen Cooper, head of Australian fixed income at First Sentier Investors, believes that positive news may well be on the horizon for bond investors as inflation worries ease.

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“For those using bonds for diversification purposes, there is scope for bonds to rally in the event of a negative economic outcome that adversely affects risk assets,” he said.

“There is scope for meaningful capital appreciation from fixed income securities in a ‘risk-off’ environment, with bonds potentially providing an offset to any weakness in risk assets as they have typically done in the past.”

While acknowledging that a reversal in outlook is not guaranteed, Mr Cooper pointed to several emerging positive signals.

Among the most important is the likelihood that central banks are “much closer to the end than the beginning” of their policy tightening cycles, with “some further moderation in the pace of tightening” anticipated in the months ahead. 

Mr Cooper highlighted that numerous major central banks have already been adjusting their communications strategy in this direction, given heightened awareness of the delayed effect of policy tightening on economic activity levels and growth.

Ultimately, he noted, the extent of further policy tightening will be driven by the persistence of inflation. 

“That path remains challenging to predict at this stage, although it’s worth noting that plenty of forecasters are suggesting interest rates could be lowered before the end of 2023 as key markets enter policy-induced recessions,” Mr Cooper continued.

“If these forecasts prove accurate, we could see more meaningful reductions in official borrowing costs in 2024.”

Reasons for optimism

After years of negative interest rates, Ms Baenninger noted that yields on fixed income assets have finally turned positive. With income now returning to the fixed income space, she suggested that investors have a number of reasons to be optimistic. 

“Over the long term, yield is by far the most stable and reliable component of total return for bonds,” Ms Baenninger said.

“Over the past 20 years, yield (income) has been the dominant driver of total returns in bond portfolios. For certain asset classes such as high yield and emerging markets, price return has been negative over the long term yet performance has been positive and very strong, demonstrating the power of yield.

“Despite the large role yield plays in total return, it only contributes a minor proportion towards total return volatility.”

Moreover, Ms Baenninger noted that investors no longer need to take unnecessary credit risk to reach for yields. 

“In a regime of ultra-low government bond yields and steep yield curves, investors in developed markets bonds were faced with a rather difficult trade-off: generate higher yields by going out further on the maturity curve and taking on more interest rate risk, or take on more credit risk by moving down the credit quality spectrum,” she says.

“At the end of last year, only a quarter of the market offered yields of more than 2 per cent (in USD). Today, this universe has more than tripled to 83 per cent. We would argue that this development allows for a much better starting point for investors to achieve their investment goals, with an ability to build a much more diversified portfolio in terms of both issuers and sectors.”

But despite the benefits of higher yields, Ms Baenninger added that investors should keep in mind that markets are likely to remain volatile over the short-to-medium term, as global central banks remain focused on stamping out persistently high levels of inflation.

“However, for long-term investors, bonds are arguably better placed today to handle any further price declines than in the past,” she concluded.

Jon Bragg

Jon Bragg

Jon Bragg is a journalist for Momentum Media's Investor Daily, nestegg and ifa. He enjoys writing about a wide variety of financial topics and issues and exploring the many implications they have on all aspects of life.