Looking for yields amidst market volatility? It’s time to revisit this asset class.

While global bonds have plummeted this year, bond yields have increased by more than two folds. Following the jump in yields, we think that value is emerging for bonds as an asset class.

Income has returned to fixed income

Credit spreads have widened significantly, which is implying that markets, to some extent, are pricing in an economic slowdown. The widening credit spreads, combined with monetary tightening, have pushed today’s bond yields to levels not seen in a long time (Figure 1). Specifically for investment grade (IG) bonds, yields have climbed to a high since 2009. Even the world’s pool of negative-yielding debt has shrunk to a seven-year low (Figure 2).

Figure 1: Bonds are offering more attractive yields today

Figure 2: Total stock of negative-yielding debt has plunged

In our view, this provides investors with the potential for higher total returns, and a relatively attractive entry point. Also, with bond yields at more alluring levels today, investors may not necessarily have to scour into risky assets (such as equities) in order to chase yields any more.

To be sure, while both global IG and high yield (HY) bonds have seen some repricing, we believe that valuations of IG bonds are more undemanding as their spreads have widened quite a fair bit by historical standards. In contrast, riskier credits like HY bonds are vulnerable to economic downturns which can raise the credit and default risks. In other words, there will be substantial room for HY spreads to widen in order to reflect the increase credit and default risk if economic conditions slow more dramatically.

Figure 3: How far can spreads really go

Credit fundamentals remain healthy

Fundamentally, the majority of global bond issuers – of which over 80% are from the US and Europe – are in a better shape today. Credit metrics, such as leverage (debt-to-EBITDA) and interest coverage, have seen improvements, driven mainly by a post-pandemic earnings recovery as well as lower total debt levels. Interest coverage ratios are particularly strong as corporates have taken advantage of the interest rate environment over the past few years to refinance their debt at lower rates.

Figure 4: Issuers have a healthier balance sheets

The healthy credit metrics suggest that corporates today are not encumbered by too much debt or insufficient liquidity, which provides cushion during periods of slowing economic growth. While fundamentals may encounter some pressure moving forward against the backdrop of rising rates and high inflation, we expect IG corporates to be more resilient due to their fair degree of pricing power, though this still varies by sector.

Bonds are now more attractive than equities

The icing on the cake is that the valuations of bonds have turned much more attractive as compared to equities – we compare this by looking at the yield of global bonds relative to the earnings yield of global stocks. It is necessary to understand that equities have a yield premium over bonds as the former carry significantly higher risk. A higher premium implies that there is more value in equities than bonds (and vice versa), as investors could receive higher potential returns from holding equities which are riskier.

However, in the current environment of rising rates, the surge in bond yields has far outpaced the increase in earnings yield. As the earnings yield (Earnings/Price) is derived by inversing the PE multiple of equities, the trend above indicates that rates have risen more than PE multiples have compressed. The result of this is a tightening spread between earnings and bond yields. In fact, the spread has reached 3.6%, which is one of its lowest points on record and is also nearly two standard deviations below the 10-year average (Figure 5).

Figure 5: Equities currently offer a lower yield premium

The tighter spread, or lower yield premium, suggests that equities are currently more expensive relative to bonds. Going forward, we expect an elevated long-term inflation rate to keep bond yields high, making the case for spreads to remain tight. With more value emerging in bonds than equities, we believe that investors should start going back into bonds, and at a portfolio level, consider increasing their fixed income allocation.

Also, we believe earnings estimates for developed market (DM) equities are overly optimistic considering the ongoing profit headwinds and macro backdrop. This means higher risk for earnings disappointment and potentially large negative earnings revisions moving ahead, implying a larger risk of negative price reactions. In our view, this warrants investors to embrace a more defensive stance – in which one way is to take on a higher exposure to bonds, especially the safer segments.

The outlook for bonds has become more constructive

On the whole, we think that the valuations of bonds have turned more attractive after the sharp sell-off this year. While not all risks (such as the probability of a recession) have been reflected in valuations yet, today’s bond issuers with their sound credit fundamentals are in a good shape to weather the uncertainties.

More importantly, fixed income as an asset class is now providing much higher yields. This creates an opportunity for investors to receive higher total returns over time, even if near-term market volatility persists.

We prefer IG over HY bonds as the latter’s spreads may have more room to widen amidst the near-term uncertainties. Within global HY bonds, nonetheless, we continue to like Asian HY as its risk-reward remains attractive in our view. Spreads of Asian HY are already at record highs, and we opine that strong government support could alleviate headwinds in the property sector, paving way for a tightening of spreads.

To be clear, short-term bond yields have moved significantly higher as compared to long-term yields, implying that investors can receive alluring yields without having to take on greater duration and credit risk (Figure 6). We also see long-term yields moving up further as investors demand a greater term premium. Hence, we continue to advise investors to be selective when adding to their fixed income exposure – our preference is for short duration bonds, and we think that it is still too early to add significant duration risk.

Figure 6: A flattening yield curve

The current environment bestows short duration bond funds with the ability to reinvest into higher yielding bonds. Our recommended products are the Nikko AM Shenton Short Term Bond SGD, United SGD Fund, and LionGlobal Short Duration Bond Fund. Amongst global IG bonds, we like the Allianz Global Opportunistic Bond Cl AMg Dis H2-SGD for its unconstrained strategy (i.e. higher flexibility in adjusting duration exposure). Lastly, for Asian HY, our recommended fund is Blackrock Asian High Yield Bond A8 SGD-H.

Table 1: Recommended products