Good time to lock in high-quality bond yields

WE’RE coming to the end of 2023; how has your portfolio fared?

Market-moving events this year may seem to justify staying in the shelter of cash. War is ongoing – in Ukraine and now in the Middle East. US Federal Reserve chairman Jerome Powell’s rhetoric remains hawkish. Powell said the Fed “will not hesitate” to raise the federal funds rate again, and that progress in slowing price stability is “not assured”.

Fixed deposit (FD) rates also remain relatively high. Why take risk when a US dollar deposit for six to 12 months could earn more than 5 per cent a year? Singapore dollar FD rates range between 2.7 and 3.6 per cent for terms of six to 12 months.

But here’s the thing. While it remains unclear when exactly interest rates in the US will turn, what most experts appear to agree on is this: We’re nearer to the end of the rate-tightening cycle than any time in the past. Based on this, it’s time to take some measured risk. Bonds, which have suffered a punishing valuation reset in the past year, now offer an opportunity to lock in higher yields for the longer term.

If rates fall, bonds benefit as their prices rise. Even if rates stay where they are – experts believe yields could stay higher for longer – high-quality bonds are likely to continue to pay coupons and eventually principal.

Personally, my joint portfolio with my husband is mainly in cash and fixed income. Direct holdings in bonds, entered into between 2021 and 2022, are still in the red. But we’ve stuck to our guns, despite the occasional call from our banker proposing a switch. Thanks to regular coupon payouts, the total return on the fixed income allocation is just slightly underwater.

The key is to take stock of the opportunities today and judiciously pick exposures where you are well-compensated for the risk. Many investors are still nursing heavy capital losses from Asia high-yield bond funds, which were hit with the double whammy of a higher-rate cycle and exposure to China’s property sector debt.

It’s surely painful to cut losses. But this decision should be weighed in the light of the opportunity for higher income today versus the prospect of a long wait to break even.

Inflection point

Capital Group’s president and chief executive Mike Gitlin, who was recently in Singapore, noted that a record amount of nearly US$10 trillion sits in money market funds globally today, compared to a “normal baseline” of around US$4 trillion over the past years.

“A lot of uncertainty pushed people into cash,” he said. “But I think we’re getting closer to an inflection point. Historically the best time to invest in the bond market is somewhere around the time of the last interest rate hike, and the first interest rate cut. Rates have moved 525 basis points in less than two years; the big move is already done.”

He added: “Now that yields are so much more attractive, I think you’re going to see cash flow out of money market funds and into active bond strategies. You’re already starting to see it. I think that pace will accelerate meaningfully in 2024 and 2025. You could see trillions of dollars move from cash to bonds over the next two years. Money will also make its way into balanced strategies.”

Here’s a snapshot of bond yields across the fixed income spectrum: US 10-year Treasuries, which breached 5 per cent in October, are now at around 4.62 per cent. Investment-grade (IG) corporate bonds yield around 6 per cent and high-yield (HY) bonds nearly 9 per cent.

Citi Global Wealth’s CIO Strategy Bulletin on Nov 5 was fairly sanguine on the investment outlook. Citi’s investment committee has raised its global equity allocation call from neutral to overweight by 2 per cent, the first such move since 2020.

“We are not taking a high-risk posture thus far,” said the Citi team, which included chief investment officer David Bailin.

“We expect no synchronised economic collapse and no V-shaped rebound. The economy is going through a series of ‘rolling recessions’ as we head into 2024. But these will ‘roll out’ in the coming year… We believe fixed income offers compelling returns at this time. Four-year duration US IG corporate bonds yield near 6.25 per cent.”

DBS expressed a “rising preference” for bonds over income equities in its latest CIO Insights report. It noted that with bond yields now expected to stay higher, it is time for investors to “recalibrate” their search for yield.

“Since August 2022, the blended yield for bonds (consisting of Treasuries and corporate bonds) has superseded the dividend yield for income equities. This suggests that the addition of income equities no longer boosts the overall yield of a portfolio. And therefore from a yield perspective, we prefer bonds over income equities at this part of the market cycle.”

Shifts in value

Stephen Tong, senior client portfolio manager with Franklin Templeton Investment Solutions, illustrates the sharp reversal of fortunes between the IG and HY segments of fixed income over 12 months in 2022.

At the end of 2021, IG corporate bonds fetched a 9 per cent premium over face value, for a yield of 2.36 per cent. At the end of 2022, IG bonds were at a discount, and yielded 5.4 per cent.

HY bonds also fetched a premium at end-2021, for a yield of 4.86 per cent. A year later, the asset class was at a discount, and yields nearly doubled to 8.9 per cent. “The charts show how fixed income drastically changed as the Fed started to increase interest rates, and this made us start to load up on fixed income as a component of the yield,” said Tong.

The asset shift is evident in the Franklin Income Fund, where the allocation to fixed income went from a low of 30 per cent at end-2021 to over 57 per cent at end-October. Over the same period, the equities allocation was reduced by more than 50 per cent, to 21 per cent.

The multi-asset Franklin Income Fund has a long history of 75 years, with total assets of nearly US$70 billion. The fund invests in equities, fixed income, convertible securities, equity-linked notes (ELNs) and cash. Its most recent distribution yield is over 8 per cent. Dividend yield on the equities allocation is around 4 per cent, and IG bonds 6 per cent. ELNs could pay between 6 and 8 per cent.

Tong said: “We think about what companies are likely to go through, and there are some headwinds. We may be able to dodge a recession, or there could be a shallow recession. But what’s uncertain is corporate earnings.”

For some top holdings in the portfolio, such as Bank of America, rather than invest in their equities, the fund invests in their debt.

“If we own their IG credit, we don’t need to worry about whether their earnings beat expectations, or whether there is a regional banking crisis in the US,” said Tong. “Our focus will be on whether they can make the interest payment. From that angle, the US IG market is definitely very healthy.”

The risks, to be sure, include a re-acceleration of inflation. In an analysis of how various scenarios could impact IG credit, Capital Group said a resurgence of inflation could cause negative returns. Still, it found that high levels of current yield would cushion losses, and the negative outcomes are likely to be less severe than in 2022.

For most investors, particularly those in or near retirement, it’s surely good news that quality bonds now offer an attractive income – plus diversification for their portfolios to boot.