- For years, investors saw stocks as the only viable option to generate reasonable returns for their portfolios. But with today’s bond yields at their highest since the Global Financial Crisis, that is no longer the case.
- Fixed income has also become more attractive relative to equities. Coupled with the headwinds to risk assets like equities during a recession, we urge investors to consider overweighting fixed income corresponding to equities.
- Within fixed income, we advocate for a move higher up in quality, with a preference for investment grade (IG) bonds over high yield (HY) bonds.
- In terms of duration, we believe investors should keep duration exposure short since a Fed rate cut in 2023 seems highly unlikely, even if a recession comes.
Gone are the decades of low inflation and an accommodative monetary policy. For years, the absurdly low interest rates meant that bond yields offered little returns. This led investors to adopt the mantra “There Is No Alternative (TINA)” as they saw stocks as the only viable option to generate reasonable returns for their portfolios.
That is no longer the case. We have entered into a different investment landscape, one that is characterised by structurally high inflation and higher for longer interest rates. Higher bond yields offer investors the potential to receive juicier returns, underpinning the growing attractiveness of fixed income as an asset class.
(Related article: How long will it take for inflation to hit 2%? Hint: much longer than you think)
Bonds have never been more attractive in more than a decade
Global bond yields – as gauged by the Bloomberg Global Aggregate Bond Index – have climbed to approximately 3.4%, akin to what was seen during the Global Financial Crisis (GFC) (Figure 1). This can be attributed to monetary tightening, along with widening credit spreads as markets price in an economic slowdown. Also, the world’s pool of negative-yielding debt, as measured by the Bloomberg Global Aggregate Negative Yielding Debt Index, has shrunk to a seven-year low (Figure 2).
Figure 1: Bond yields have surged to 2009 levels
Figure 2: Negative-yield bonds have almost disappeared
Meanwhile, credit fundamentals across the global credit universe remain in good shape, with debt metrics having experienced a meaningful fall from their peaks during the Covid-19 pandemic. Besides, corporates hold ample liquidity, as interest coverage ratios are particularly strong after taking advantage of the low interest rate environment over the past few years to refinance their debt at lower rates.
At this point, there is hardly any doubt that the fixed income universe is providing investors with a fairly attractive entry point. The higher yields, combined with healthy credit fundamentals, should enable fixed income as an asset class to play a more relevant role in enhancing the risk-reward ratio of portfolios.
Fixed income now relatively attractive compared to equities
To further illustrate the attractiveness of fixed income, we compare the yield of global bonds against the earnings yield of global stocks (i.e. inverse of the PE ratio). The surge in bond yields has continued to outpace the increase in earnings yield, causing the yield spread between equities and bonds to narrow further since our last update, reaching 3.2% (Figure 3).
Figure 3: Bonds have never been more attractive since 2009
This is its lowest point on record since 2009, and is now over two standard deviations below the 10-year average, suggesting that equities have become relatively more expensive as compared to bonds. There is no clear need to pile into risky assets such as equities to chase yields or returns any longer. The days of TINA are over – investors should start going back into fixed income.
Furthermore, it is our view that the global economy will sail towards a recession in 2023, though it will likely to be milder than that experienced in 2008. The Fed tightening is already starting to bite, with leading economic indicators pointing to a slowdown. Beyond the US, Europe is struggling with high inflation and the threat of an energy crisis, while China is expected to enter a low-growth phase.
A global recession is sure to provide headwinds for risk assets like equities. Companies would see margins increasingly under pressure and experience slower earnings growth, paving way for a moderation in equity returns (due to a larger risk of negative price reactions).
With the restoration of relative attractiveness compared to equities as well as the headwinds to risk assets, we urge investors to consider overweighting fixed income corresponding to equities.
Prefer quality and short duration
Within fixed income, we prefer to move higher up in quality. High yield (HY) bonds do offer attractive income, but a defensive positioning may be more important in a recessionary environment. As with equities, a similar argument goes for riskier credits like HY bonds – dampened margins and slowing earnings growth could significantly raise credit and default risks, and further widen credit spreads. Currently, the credit spreads of global HY bonds remain narrow as compared to historical levels, and the higher sensitivity of HY bonds to the economic outlook indicates greater room for spread widening (Table 1).
Table 1: Peak credit spreads during past recessions
|
Event |
Global HY (bps) |
Global IG (bps) |
|
Tech Bubble |
1,042 |
46 |
|
GFC |
1,703 |
149 |
|
COVID-19 |
1,008 |
82 |
|
Historical Average* |
552 |
49 |
|
Current |
545 |
53 |
|
*Since 2000 Source: Bloomberg Finance L.P., iFAST Compilations Data as of 7 December 2022 |
||
Hence, we favour investment grade (IG) bonds over HY bonds, as an allocation to safer segments would ensure that investors can capture the higher yields from fixed income without having to take on undue credit risk.
In terms of duration, our preference is for short duration bonds. The shape of the US Treasury yield curve is very flat, with the spread between the two-year and 10-year yields as well as the spread between the three-month and 10-year yields inverted. Given that yields on the shorter end have moved up considerably higher compared to yields on the longer end, short-term bond yields are currently more competitive (Figure 4). This implies that there is no yield pick-up for extending duration. As such, investors can lock in attractive yields without having to take on greater duration risk.
Figure 4: Value is to be found at the shorter end
While long duration bonds historically outperform during a recession, we believe that this time is different. We see the potential for long-term yields to move up further, due to our view that markets are underestimating the persistence of inflation. And even with the impending recession, we reckon that a Fed rate cut in 2023 seems highly unlikely (we are leaning more towards a Fed pause). The slope of the yield curve is not expected to steepen meaningfully without a rate cut, suggesting that it is not yet time to shift towards long-dated bonds.
Moreover, short duration bonds can benefit from the “pull-to-par” effect, meaning that even as the bonds experience mark-to-market losses because of market volatility, they should produce some upside for investors as their prices approach par value upon maturity. Meanwhile, longer-dated bonds typically do not benefit from this pull effect since the maturity date is too far away to provide a reasonable amount of certainty regarding principal repayment and market yields.
Considering the above, the best place to be is in short-dated, IG bonds.
Pay more attention to fixed income, if you haven’t already
In summary, investors can no longer lament about bond yields being absurdly low. Higher interest rates have enabled bonds to present attractive yields not seen in more than a decade. With bonds now able to serve as a viable alternative to stocks, it is time to put the days of TINA behind us.
From a portfolio perspective, we prefer fixed income over equities. This comes as fixed income has finally regained its relative attractiveness compared to equities, and with our expectations of the global economy sailing toward a recession in 2023 that would slow earnings growth.
A defensive positioning applies within the fixed income universe as well. We believe investors should stay up in quality by opting for IG bonds to capture the higher yields without taking on undue credit risk. The duration exposure should also be kept short – value is to be found in short duration bonds, as investors can receive attractive yields without having to take on greater duration risk. Furthermore, we believe that a Fed rate cut in 2023 seems highly unlikely – even if a recession comes – implying that it is not yet time to shift towards long-dated bonds.
All things considered, our highest conviction is in SGD-centric short duration bonds as our recommended funds currently hold portfolios that yield at least 5%. An unconstrained bond strategy found among global bond funds is also viable as they can react quickly to changes in market circumstances, such as adjusting their duration exposure along the interest rate cycle. Lastly, among Asian credits, we favour IG over HY after exercising a cautious stance on the latter.
(Related article: Downgrading Asian high yield: Why we aren’t taking this risky bet anymore)
Table 2: Recommended products
|
Market |
Product |
Related article |
|
Short Duration Bonds |
3 recommended funds that can give you higher rates than fixed deposits |
|
|
Global Bonds |
An unconstrained bond strategy really shines during market uncertainties |
|
|
Asian USD IG |
After yields have climbed to 6%, Asian investment grade bonds are starting to look compelling |
Moving into 2023, we also expect the US dollar (USD) to peak as the pace of Fed rate hike slows and eventually pauses, while other central banks play catch-up. The trend of de-dollarisation given today’s increasingly multi-polar world provides further reinforcement for the USD strength to wane. Therefore, we advise investors to hedge their USD exposure where possible. This is especially important for fixed income assets, as yields could be eroded by currency movements.
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