UP until early this year, strategists celebrated the return of income to fixed income; and urged investors to move out of cash, on the strength of higher yields in bonds.
But now, as the near-term prospect of interest rate cuts by the US Federal Reserve fades, investors are nursing price losses, particularly in longer-duration bond funds.
Is the fixed income asset class heading for another year of losses? On the flip side, yields have now become even more attractive. Better still, bonds and equities are moving in opposite directions, working as they should to provide diversification in portfolios.
To recap, from around the third quarter of last year, markets optimistically priced in up to six rate reductions by the Fed for 2024. This fuelled the ongoing bull market in equities. Longer duration bonds would also benefit from rate cuts, as their sensitivity to interest rate changes would result in more capital gains. This encouraged investors who sought to lock in higher yields for longer periods.
But recent US economic data dealt a double blow: weaker than expected economic growth of 1.6 per cent for the first-quarter gross domestic product and stronger-than-expected core inflation of 3.7 per cent. Stubborn inflation put paid to hopes of early rate cuts.
Resetting rate-cut expectations
Bond prices fall when rates rise and vice versa. The Fed has yet to move, but just the expectation of possibly zero cuts – or far fewer cuts in 2024 than earlier anticipated – is enough to cause bond prices to fall and yields to rise.
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Based on Morningstar data for year-to-date returns from fixed income funds, most bond segments are in the red up to mid-April. In US dollar terms, global bond funds generated average returns of minus 4.3 per cent, and global corporate bond funds minus 3.6 per cent. The broad category of Asian bonds fared relatively better, slipping by 0.29 per cent in US dollar terms; but in Singapore dollar terms, the segment lost 4.78 per cent.
Asian high-yield (HY) bonds were an exception, with year-to-date returns in positive territory, a welcome respite after a disastrous couple of years between 2021 and 2022, when their exposure to China debt dealt heavy losses.
Among some strategists, expectations of rate cuts are now pushed further out into December or even 2025, although the latter view is not consensus – which appears to be one to two rate cuts this year.
Tom Porcelli, PGIM fixed income chief US economist, said that rate cuts may not happen at all this year. He noted that for a cut to take place in July, inflation readings would need to quickly meet the requirement for a “string” of constructive inflation reports.
“Much would have to fall in place for cuts in July and December, such that we would place a higher probability on zero cuts than two cuts,” he added. “If the Fed is hindered from cutting rates this year, it could shift those into 2025… As at this point, three cuts are expected next year.”
Devinda Paranathanthri, UBS CIO credit strategist, expects 50 basis points (bps) of cuts to begin in September. The bank’s earlier forecast was 75 bps starting in June.
Cushion from bonds’ higher yields
For now, strategists are relatively sanguine on fixed income as higher starting yields are expected to cushion losses.
Rick Cheung, portfolio manager for emerging market debt at BNP Paribas Asset Management, said: “The current level of yield gives investors a much better entry level to lock in long-term return in fixed income. We might see another negative return for fixed income this year unless inflation or economic activities suddenly decrease significantly. But the starting level of fixed income is very different from 2022, given the yield level is much higher now. We continue to be bullish on fixed income and think buying on dips will enable investors to enjoy a stable long-term income.”
Daryl Ho, DBS’ senior investment strategist, said that long-duration bonds could see a negative year. “But it is quite unlikely for short-duration bonds to see negative total returns due to the high coupon rates of close to 6 per cent in investment-grade (IG) credit in the three- to five-year tenors.”
He said the bank took the view that the expectation of six to seven rate cuts for 2024 was too optimistic, and advised investors to remain in shorter duration bonds. “Likewise, markets could be too hawkish now,” he added. “Our fixed income strategy at DBS was nuanced in 2024; while we were positive on bonds, we also raised caution that the path to lower rates might not be as straightforward as initially imagined due to the strength of the private sector and persistence of inflationary forces.”
Samuel Rhee, Endowus chairman and chief investment officer, said investors should note that fixed income returns comprise income from interest rates and capital gains from price action of liquid bonds. “While prices have fallen, yields still are high and good,” he noted, adding: “Therefore, we’ll see throughout the full year that the yields will compensate for the price action; and we’re likely to end the year similarly as last year – with a small positive outcome...
“We are only four months in, and so we’ve only gotten 25 to 30 per cent of the positive yield carry for the full year, but probably 80 to 100 per cent of the negative price move. Over the course of the year, this will likely normalise to a positive eventual number. So when price moves are over, it is not a bad time to go back into fixed income.”
On Asian bonds, Arvind Subramanian, Morningstar’s senior analyst of manager research, said Asian bond funds are expected to remain relatively resilient. “In the current year, while credit spreads for Asian bonds are relatively tight, the absolute yields for investment-grade and high-yield bonds are notably high… If interest rates remain stable and credit defaults remain low, bond funds should be capable of providing reasonable returns, even in the absence of rate cuts.”
As for Asian HY bond funds, Rhee noted that China bonds have rebounded after hitting bottom in October 2023, “and have been steadily recovering both from the credit risk and with stronger yield performance”. He added: “So if you had gone in or held on then, you would have had positive returns and less volatility than many other fixed income sectors.”
Many investors, however, are likely still nursing losses from funds’ earlier exposure to troubled China debt, particularly to the shaken real estate sector. Asian HY bond funds generated returns of 2.74 per cent year to date, but are in the red on average for longer periods. The annualised loss over three years was 11.65 per cent, and 5.95 per cent over five years.
Paranathanthri of UBS preferred Asian US-dollar IG bonds, “as they offer better risk-reward at current yields (5.8 per cent)”. He noted: “Credit spreads for Asia IG are at historical tight levels at 125 bps, but we expect spreads to stay at these levels for the remainder of the year as technicals remain strongly supportive. Higher yields are bringing demand for IG, but net issuance in Asia is firmly negative at US$9 billion in Q1 2024.”
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