Exploring the potential for a bond rebound.
As inflation continues its move lower, is the outlook for bond investors brightening? After a really tough 2022, fixed income may be set for a recovery as key interest rate increases are slowing and likely to end, and a potential recession is on the horizon.
As we move through the remainder of 2023, here are a few things to consider: The risk-free rate has risen substantially, providing favourable yields and a chance to “clip the coupon,” or benefit from higher interest income. Longer-duration government bonds offer good potential price appreciation if we enter a recessionary environment because bond prices move in the opposite direction of interest rates. For example, bond prices fell as interest rates increased throughout 2022 Bonds may resume their historical negative correlation to stocks, in which case they may provide downside protection during equity market slides
A good way to capture the present opportunity could be using a bond fund. Fixed income portfolio managers are excited about the coming year.
A deeper dive
With bonds and equities selling off together in 2022, there was nowhere for investors to hide outside of holding cash. Pundits proclaimed the death of the popular 60 per cent equity/40 per cent bond portfolio, and many investors were left scratching their heads and wondering how to invest their savings.
This market volatility resulted from an unprecedented combination of global events over the last few years. First, the COVID-19 pandemic, with consequent border closures and lockdowns, slowed economic growth and disrupted supply chains.
Policymakers tried to prop up struggling economies by slashing interest rates to zero and providing wage support for workers affected by the pandemic. The resulting increase in the money supply contributed to inflationary pressures throughout the global financial system, and inflation rose sharply.
This decades-high inflation forced central banks to increase interest rates at a rapid pace. Equity markets, especially tech stocks and riskier assets, suffered, as debt-laden companies could not afford to find and secure financing. Bonds also suffered because rapidly rising interest rates pushed bond prices lower.
Borrowing costs are now at their highest levels since 2007, due to an unprecedented cycle of interest rate increases, and higher interest rates appear to be slowing down both the global economy and inflation. It’s widely expected that central banks will begin to gradually slow both the frequency and the size of rate hikes this year.
In fact, many indicators are now signaling a recession. But this possibility also presents an opportunity for bonds: interest rates typically fall during recessions, which would increase bond prices.
Wait and see
In the current environment, a wide variety of bonds offer attractive income – from government debt and high-quality corporate bonds to high-yield corporate debt. This is very much a “wait and see” period for fixed income investors, a good time to “clip the coupon” and take advantage of current higher yields as the U.S. Federal Reserve and the Bank of Canada decide how to respond to the economic conditions in the first half of 2023. Because high-quality corporate debt is providing attractive yields, investors do not need to take on additional risk in the high-yield or “junk” space.
Moreover, high-quality credit helps mitigate duration risk in case rates continue to rise, because yields on high-quality corporate debt provide a cushion against any future interest rate increases. While high-yield debt may offer even higher income, in periods when defaults rise and recessionary signals emerge, the price declines of high-yield bonds often exceed their income. Credit quality is therefore an important consideration at the current time.
Bonds typically outperform in recessionary environments. Not only do they pay a steady stream of income, but as the central banks adapt to recessionary forces by lowering rates, bond holders could also see some capital appreciation. In periods when economic conditions deteriorate materially and interest rates are stable or likely to decrease, duration becomes the focus for the bond investor. Adding longer duration government debt to a portfolio can increase potential price appreciation as interest rates fall.
Once the full effects of a recession are experienced and market expectations have been established, there may be opportunities in the high-yield credit space. When markets have fully priced in a recession, high-yield spreads typically increase. This is because as the expectation of defaults rises, investors require a higher spread compared to safer bond investments. Debt from some companies can be unfairly punished as default rates rise. A portfolio manager with deep credit research abilities should be able to identify opportunities in this space.
Looking at 2023 and beyond, bonds are geared to become a meaningful part of client portfolios again. Attractive current rates mean clients can get paid to wait as the central banks navigate the choppy waters. Once we start to see the potential for rate cuts, duration comes to the forefront, and long-term government debt could be a good place to withstand a recessionary environment. Finally, when the markets have fully priced in a recession, bargains may exist in the high-yield space.
Bond managers with deep credit analysis experience and an unconstrained mandate to find the best opportunities around the globe may be best positioned to take advantage of the changing environment over the next few years.