Why Everyone's Talking About… Bonds

For much of the past few years, the acronym TINA has rattled around markets. Whenever anyone began to have doubts about how high equity markets were getting, someone would end the discussion by pointing out There Is No Alternative – and, with interest rates at historic lows, there often wasn’t.

Fast forward to 2023, however, and things look drastically different. After a terrible 2022 – the Bloomberg global aggregate index, a broad measure of global fixed income, fell over 16% during the year1 – so far, 2023 has been pretty good. A key reason for this is that much of the pain of 2022 came because of extreme moves by central banks intent on curbing inflation.

The US Federal Reserve raised interest rates seven times, taking the fed funds rate from 0.25% in January of 2022 to 4.5% in December, the highest level since 20072. The Bank of England went even further, hiking rates eight times over the same period.

This saw bond prices plummet and yields, which move in the opposite direction to prices, jump. As a case in point, at the start of 2022, there was $14 trillion worth of negative yielding bonds in the market. In January that number had shrunk to zero – the first time since 2010 that there has been no negative yielding debt3.

On top of this, many investors are currently far more sanguine about the market outlook than they were at the start of last year. As our 2023 Fund Selector Survey shows, while inflation (70%) and interest rates (63%) remain the chief portfolio concerns, three quarters of fund selectors also believe that rising interest rates will usher in a resurgence in bonds.

Part of the reason for this is that starting points matter. As the old saying goes, the first cut is the deepest – so a hike in interest rates from near zero to 0.5%, or even from 1% to 1.5%, is likely to come as a bigger shock than a hike from 5% to 5.5%. That’s not to say that further hikes won’t have an impact, but the many market participants are expecting rates to peak sometime this year and the difference in market impact of a terminal rate 5.25%, 5.5% or 5.75% will be minimal – all three options are a very long way from 0%.
As interest rates rise, so bond prices tend to fall and, as a result, bond holders will lose out in the short term, but higher interest rates are good for the income side of the bond equation. If central bank rates are higher, so other rates, like the rate of interest offered on new bonds is higher too and, as such, rising rates mean a greater level of income, which compounds over time and means that coupon payments can be reinvested at higher rates too. All of which is good news for investors looking for an income from their bond portfolio.
At the start of March, the yield curve for US Treasuries, (which plots the yield of bonds against the number of years they have until maturity) was more steeply inverted than it has been in 42 years4 as economic data has surprised investors and changed common market assumptions about the level at which interest rates will peak.

An inverted yield curve – when short term bonds offer higher yields than longer term bonds – is considered by many to be an indicator of recession and typically happens when investors believe that interest rates are likely to continue to go higher in the near term.

As Julian Dauchez, head of Portfolio Consulting at Natixis Solutions points out: “Looking at the portfolios we analyse, investors are favoring the short end of the yield curve in the US, in Europe and most developed markets. Now, things will evolve and come the end of the year, when we believe bond market volatility will recede as short-term rates find their terminal level, there is an expectation that the yield curve will steepen again and offer meaningful opportunities in the long end of the curve.”
No. If 2022 taught markets anything, it was that fundamentals are important. While many in the market are of the view that 2023 could well be the year of bonds, it is not an environment where everything is cheap, or even one in which all instruments have gone down by the same amount. The current market environment remains complex and while there are likely opportunities to be found, expertise is required to find them amidst the volatility.
In short, 2022 was a forceful reminder that, while bonds and stocks have tended to move in opposite directions for the past 40 years, such anti-correlation is not an immutable law. As a result, it also demonstrated the limits of 60/40 funds, which use this tendency toward anti-correlation as a cornerstone of the investment thesis. As such, many investors are considering other methods of diversification.

As Julian Dauchez, head of Portfolio Consulting at Natixis Solutions explains: “This year, there is expectation that decorrelation between bonds and equities may gradually come back as inflation recedes, but investors are also taking a proactive approach by diversifying their portfolios with alternatives. Liquid, non-directional strategies as well as illiquid alternatives – and those such as infrastructure which can also offer inflation protection for institutional investors – are being favored by investors.”

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GLOSSARY
  • Bond – the ‘bond market’ broadly describes a marketplace where investors buy debt securities that are brought to the market, or ‘issued’, by either governmental entities or corporations. National governments typically ‘issue’ bonds to raise capital to pay down debts or fund infrastructural improvements. Companies ‘issue’ bonds to raise the capital needed to maintain operations, grow their product lines, or open new locations.
  • Duration – A measure of a bond’s sensitivity to changes in interest rates. Monitoring it can effectively allow investors to manage interest rate risk in their portfolios.
  • Fixed income – An asset class that pays out a set level of cash flows to investors, typically in the form of fixed interest or dividends, until the investment’s maturity date – the agreed-upon date on which the investment ends, often triggering the bond’s repayment or renewal. At maturity, investors are repaid the principal amount they had invested in addition to the interest they have received. Typical fixed income investments include government bonds, corporate bonds and, increasingly in recent years, green bonds. Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity.
  • Yield – A measure of the income return earned on an investment. In the case of a share, the yield is the annual dividend payment expressed as a percentage of the market price of the share. For bonds, the yield is the annual interest as a percentage of the current market price.
  • Yield curve – Essentially, it is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates. So, the curve shows the relationship among bond yields across the maturity spectrum – this is considered ‘normal’ when the yield on long-term bonds is higher than the yield on short-term bonds. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year US Treasury debt. It is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates, and it is also used to predict changes in economic output and growth.
1 Source: https://www.ft.com/content/da3d4b6d-f454-475c-b886-a93585813bc6
2 Source: https://www.federalreserve.gov/monetarypolicy/openmarket.htm
3 Source: https://www.ostrum.com/en/news-insights/news/mystratweekly-january-10th-2023
4 Source: https://www.ft.com/content/a6c270d8-78e0-4df8-bf61-24fd6f914924

This material is provided for informational purposes only and should not be construed as investment advice. Views expressed in this article as of the date indicated are subject to change and there can be no assurance that developments will transpire as may be forecasted in this article.