Bonds benefit from 4-decade discounts and elevated yields
This combination presents a rare opportunity to capitalise on higher yields and enhance total return potential as bond prices get pulled to par over their maturity terms
THE strong interest-rate rally from 2023 paused in the first half of 2024, with yields remaining in rarified air. While some major central banks initiated rate cuts, the US Federal Reserve remains a key outlier for now by holding rates steady. Markets cheered when the Fed signalled at its latest meeting that its next move will likely be a cut.
Against this backdrop, we maintain a bullish outlook for fixed income assets and think it is a compelling entry point.
High-yield fixed income attractive on risk-adjusted basis
Today’s elevated yields provide a favourable environment for bond investors. Structural shifts have pushed rates higher in a durable way, reflecting more normalised conditions, unlike the very compressed rate cycles seen after the global financial crisis, throughout and post-pandemic.
We think 10-year Treasury yields may hover between 3.8 and 5 per cent, with no expectations to dip down to the lower territory of recent years. This creates a favourable scenario for bond investors, with attractive starting yields that provide a stronger outlook for forward-looking returns.
Fixed income markets are also trading at significant discounts, with US investment-grade (IG) bond prices near their lowest levels in more than 40 years. Given the high correlation between starting yields and five-year forward returns, we believe this combination presents a rare opportunity to capitalise on higher yields and enhance total return potential as bond prices get pulled to par over their maturity terms.
Given that rates have fallen within six months of the Fed’s first rate cut, investors waiting for cuts to commence may miss the opportunity.
BT in your inbox
Start and end each day with the latest news stories and analyses delivered straight to your inbox.
From an asset-allocation standpoint, we are in a much more balanced risk/reward regime than before. Ten-year US bond yields currently exceed equity earning yields as measured by the S&P 500, making fixed income a more favourable option from a risk-adjusted return perspective.
Historically, bonds offer attractive risk-adjusted returns following central bank pauses. For instance, following Fed pauses, IG corporates returned about 8 per cent per annum comparable to US stocks returns (about 9 per cent) on a three-year basis – but with less than half of its volatility.
Additionally, stocks and bonds tend to have low correlations when central bank policy shifts to holding or cutting patterns. Bonds have historically been good shock absorbers, delivering solidly positive returns when equities plummet. With rising geopolitical risks, potentially higher volatility strengthens the case to diversify into bonds.
Investors now have the opportunity to lock in higher starting yields that are at levels not seen in a decade. We expect bonds to offer a greater total return profile, while being able to absorb shocks from equity market corrections. Cash yields are less sustainable in a slowing economic environment, given the scope for central banks to slash rates.
Investment opportunities
Ongoing macro and geopolitical uncertainty will continue to create a deep opportunity set for adding value through issue, sector, term structure and currency positioning.
US and German 10-year government bond yields are likely to remain elevated, providing the main source of returns. We are less convicted on directional views as we see two-sided risks: reflation and fiscal risks to the upside, disinflation and recession to the downside.
IG credit spreads have tightened in the US and Europe, making carry a more likely source of returns than spread compression. Spread dispersion and macro volatility will present opportunities for active managers, especially with higher all-in yields in credit.
Emerging hard-currency debt also presents opportunities as macro uncertainties, the dispersion in quality, fundamentals and valuations offer opportunities. Emerging markets local debt offers high carry and price gains potential where their central banks have room to cut.
Yields continue to moderate as markets await Fed rate cuts, giving investors a short window to extend duration now and lock in higher rates.
High-yield spreads are close to fair value, but looking beneath the hood, the dispersion in this segment is the highest we have seen in a couple of decades. We think the market is underpricing global geopolitical risk and uncertainty, providing active opportunities to add risk and reward accurate credit selection.
A new regime of higher bond yields makes fixed income assets very attractive for long-term investors. With elevated bond yields, a favourable risk-reward profile compared to equities, and the potential for capital appreciation as rates decline, the current fixed income landscape presents a compelling opportunity for investors to enhance their portfolio’s total return potential.
Gregory Peters is co-chief investment officer, and Tom Porcelli is chief US economist, PGIM Fixed Income
Copyright SPH Media. All rights reserved.
