Bonds – if not now, then when?

Which areas of the fixed income market are most attractive at the moment?

Olivia Buah

Senior Consultant

The bottom line:

Much of the bond market is more attractively priced now than it has been for much of the past decade. Investors thinking about making an allocation should be asking themselves: if not now, then when?

This year has been the ‘worst year in history’ for bond markets, with the Bloomberg Global Aggregate Total Return Index (a key measure of the worldwide bond market) seeing its biggest slump since its inception in 1990. The index has lost more than a fifth of its value from its record high in 2021.

The Bloomberg Global Aggregate Total Return Index is down over 20% since its peak in 2021 (on an unhedged basis)

With global struggles of persistent inflation and central banks tightening monetary policy, we have seen significant increases in interest rates and credit spreads (i.e. the additional yield on corporate bonds compared to their government counterparts). All things equal, bond prices fall when interest rates rise or credit spreads widen, therefore both of these happening at once led to large falls in value for the majority of fixed income markets.

Traditionally, bonds have been seen as a ‘safe haven’ asset and a diversifier to equities in a portfolio. But with equity markets also taking a tumble this year, bonds in general, did not offer the protective characteristics one might have anticipated. So an investor might well ask, why invest in bonds?

The good news is that if you are looking to invest new money into fixed income, you can now do so at cheaper prices and a higher yield. Around three quarters of the global corporate bond market now yields over 4% pa to investors, compared to only a very small fraction of the market a year ago. That’s a pretty healthy return, so maybe, in fact, bonds are back?

Both investment grade and high yield global corporate bonds are offering some of the highest yields in the past decade

Source: Refinitiv Datastream, 13 October 2012 to 13 October 2022

The attractive-looking returns on offer come amid a challenging economic backdrop. It may have been one of the hottest summers on record in the UK but this wasn’t enough to thaw Brits’ doom and gloom attitude, with UK consumer confidence at its lowest levels in 50 years. Consumer confidence is also low in the US and Europe, as the rising cost of living cast a shadow over people’s finances. A possible recession and the knock-on effects this would have on the ability of companies to meet their debt obligations don’t bode well for bond markets. In addition, further increases in interest rates would have a negative impact on the prices of fixed rate bonds, with a larger impact for bonds with higher ‘duration’ (a measure of a bond’s sensitivity to movements in interest rates). So you may be wondering, is now a good time to invest in credit markets, and if so, where?

Different things to different people

Bond markets are very different to equities and other asset classes, in that there is such a broad spectrum of types of credit, which can serve very different purposes for each investor.

For instance, fixed interest government bonds can help match certain movements in a pension scheme’s liabilities. However, we wouldn’t say they are a good asset for other investors looking to either grow their assets or protect the real value of their money in a high inflation environment.

There are four key factors that can be used to categorise the bond market:

The case for investing in fixed vs floating rate products is explored by David Wrigley in his article.

We take these factors into account when helping our clients to think about where might be most attractive to invest at the moment.

Better safe than sorry?

Data shows that high-quality investment grade issuers currently have healthy balance sheets and solid fundamentals. This means in the round they should be able to manage impending economic challenges and repay investors the money they have borrowed. This means you could be getting more for your money than a year ago, still with the peace of mind that comes from lending to higher quality companies.

We prefer a buy and maintain approach when it comes to investment grade, where an investment manager buys high-quality bonds and aims to hold them to maturity. We think this offers a good balance between active and passive management styles, which keeps transaction costs and management fees low. We expect managers to focus on avoiding downgrades and defaults. If you expect interest rates to keep rising, you may wish to consider reducing the duration of the portfolio. Furthermore, investing on a global basis helps diversify your portfolio against country-specific risks.

Do higher risks mean higher returns?

In the sub-investment grade space (i.e. lending to companies with a credit rating of BB or below), yields have risen by more than investment grade bonds and it is significantly more attractive to enter the market now than at the start of the year.

Global sub investment grade yields have doubled this year, from 5.1% pa to 10.0% pa

Having said that, there is an indication of a 'Covid hangover' evidenced by interest coverage ratios falling (meaning companies have less money to make their debt payments with) and default rates increasing. Investors should proceed with caution here.

We believe the best way to access sub-investment grade markets is via a multi-asset credit strategy. Asset managers are well placed to decide which areas of the high yield market to invest in (including US and European high yield debt, asset-backed securities and floating rate loans) and can react quickly should market conditions deteriorate.

Could locking up your money for longer give a better opportunity set?

The flow of capital from institutional investors into illiquid credit assets is probably one of the biggest investment trends of the last decade.

The most straightforward type of illiquid credit is known as ‘direct lending’, which is lending money directly to small and medium-sized companies (i.e. pretty much as it says on the tin!). Historically as traditional banks stepped back from lending to these companies, institutional investors stepped in to fill the gap in the market, leading to sizeable returns for those willing to lock their money up for the medium term. Unfortunately, given the rise in yields for other credit assets, although decent returns are still available, investors are no longer being compensated for illiquidity to the same degree they once were.

However, the good news is that the illiquid credit universe is so much more diverse than just direct lending.

The wide range of approaches within illiquid credit

In particular, our view is that infrastructure debt offers a number of very attractive features, including steady, reliable returns with a low correlation to mainstream asset classes. The underlying companies typically operate in a market where there are considerable barriers to new entrants and strong pricing power. Deals in this space are often inflation-linked and ‘floating rate’, offering protection against both rising inflation and rising interest rates. Investors can access responsible investment opportunities such as renewable energy and social projects, which contribute to moving the economy towards net zero carbon emissions and making things better for the wider society. What’s the catch?! Well, the length of time you need to lock up your money in infrastructure debt funds can be significant so this is really only suitable for long-term investors – but, if you’re happy to be tied up in bonds for upwards of 10 years, then it's worth considering.

Another option if you are looking for higher expected returns is opportunistic credit. Specialist managers can step in when a company is in a stressed situation, but they believe the company will recover (often with the managers’ guidance and expertise). Typically the debt is purchased at a significant discount, with large upside potential. With a potential recession looming in multiple markets globally, this could present more opportunities for these managers to deploy capital at attractive prices. However, investors should always be mindful that with a high expected return comes a greater level of risk.

Conclusion

Ultimately, diversification matters for your bond portfolio, as some parts of the market are delivering returns when other parts are not.

The asset class means different things to different people – bonds could be return generators, hedging instruments or a source of regular income. It’s a broad asset class with a lot of diversity, and there’s something for every investor.

What we can say is that much of the bond market is more attractively priced now than for much of the past decade – as the market’s interest levels have perked up, so have investors’.

Investors looking for security could construct a portfolio of investment grade bonds; while those who can afford to lock up their money for longer could look to illiquid credit, which ranges far wider than the more well-known ‘direct lending’ approach.

While the economic environment looks challenging, many credit assets look resilient and others could even thrive. Investors thinking about making an allocation should be asking themselves: if not now, then when?