Fixed income: back in favour?

After a challenging period, bond markets have benefitted from the new economic environment. David Arnaud explains why there is now a strong case for investing in fixed income.

In 2022, gilt portfolios, historically a very safe allocation, lost 25% in value as yields jumped from 0% to 5%. This represented the worst period in modern history for gilt returns, triggered by a sharp repricing of market rates after central banks, including the Bank of England (BoE), hiked interest rates more than 5% in eighteen months – a speed unmatched in recent history.  The reasons behind this have been widely telegraphed: a sharp rise in inflation – which went from under 1% at the beginning of 2021 to 11% by the end of 2022, caused by the demand for goods outstripping supply during Covid, coupled with the energy shock triggered by the Russian invasion of Ukraine.

Investors have understandably been bruised by this period, but this environment has now changed dramatically as inflationary forces have subsided; economies globally have reopened, and factories are now operating normally, which has considerably eased pressure on the supply side. The energy crisis that investors feared in 2021/2022 also failed to properly materialise, while oil prices have come down significantly since that period. That is starting to filter through to the housing market and rents, pushing prices back down. The primary source of inflation left in the system is services inflation, specifically wages.

Taken all together, this means that the descent towards the 2% target level for inflation has started, and is going to continue. According to the BoE, we are going to see inflation touch 2% this year and it should stabilise between 2 and 2.5% next year. These levels of inflation are a lot more sustainable than previously – and do not require interest rates to be kept at 5%.

Bond yields have started their descent

Last year there was considerable excitement at the prospect of rates coming down as quickly as they rose, resulting in a notable fall in 10yr UK gilt yields from their 4.75% peak to around 3.50%. However, the narrative emanating from central banks has shifted since, and timings of upcoming rate cuts have been delayed as progress on inflation has fallen short of expectations. This uncertainty has caused volatility to spike since the start of 2024, as markets try to determine the start date and magnitude of the monetary policy easing cycle.

We expect the BoE to deliver three rate cuts this year for a total of 75bps, and a similar amount next year. We believe that UK interest rates will stabilise within a 3.50-4.00% range – a considerable difference from the current 5%, which will ultimately bring gilt yields down as well. At the moment, the keyword in markets is patience: although cuts have not yet begun, central banks are no longer pushing back on the concept of upcoming interest rate cuts, and that is a very important factor in sentiment.

The case for fixed income allocation

We believe that there is a strong case for investing in fixed income in 2024. In our view, the recent stock market gains we have seen are unlikely to be repeated, for the reason that signs of a meaningful economic recovery have failed to materialise, and many of the gains we have seen in the past year represent the bounce back from Covid and a boost from accumulated consumer savings.

Another important factor to consider is GDP growth, which is expected to remain very modest this year. In this environment, a strong equity market is unlikely, and when the economy is muddling through, fixed income is usually a more favourable allocation for positive returns. Investment grade markets have proved very resilient overall, making them a very appealing place to invest as all-in yields continue to sit at multi-year highs. This is particularly true of companies that issued a significant amount of debt pre-Covid, thereby building a liquidity buffer that helped them weather lockdown and the period that followed. This means that it is less important for these companies to raise additional debt, a very supportive factor for the fixed income market. These companies have also been able to pass on price increases, (which has also been a factor in generating inflation) meaning that margin has been maintained, despite higher costs and higher wage demands from employees.

Creating opportunities to add duration to portfolios

In our view, there is now an opportunity to access current yields before interest rates stabilise at lower levels. UK corporate bond investors can currently achieve yields in excess of 5% without taking excessive credit risk. We see this level as an attractive entry point and are adding back duration to our portfolios to generate capital gains in anticipation of policy rates coming down. These are some of the opportunities that we are seeing today.



Important Information

The value of investments may fall as well as rise and investors may not get back the amount invested.

The views expressed in this document are those of the fund manager at the time of publication and should not be taken as advice, a forecast or a recommendation to buy or sell securities. These views are subject to change at any time without notice.

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Promotion approved 14/05/24