For much of the past 40 years, bond prices have risen1. Built on a concomitant decline in interest rates over the same period, it is such an enduring trend that entire investment careers have started and ended never knowing anything else. In 2022 however, it moved from friend to foe, and, in its wake, an old friend reappeared – yield.

This new trend continued for much of 2023, but, just like the story of the prodigal son, yield’s return wasn’t welcomed by everyone. The economic conditions that heralded its return in 2022 – inflation expectations, the prospect of higher interest rates and punishing falls in both bond and equity prices left many investors rather bruised at the start of 2023 and many chose to stay on the side-lines for much of the year.

As Julien Dauchez, Head of Portfolio Consultants at Natixis Investment Managers Solutions explains, the resurgence of inflation, the escalation of geopolitical tension and higher rates, all contributed to create a sticky pessimism with investors and, in this context, it is not surprising that many investors looked for safety; the safety of cash, and the relative certainty of Hold to Maturity Bonds, which generally offer a secure yield. Our analysis shows that typical wealth managers’ allocations to cash and money market funds rose during 2023 and reached a peak close to 17% just after the summer, That exceeded even what we saw during the covid crisis.”

And, while yields rose steadily throughout much of 2023 – the yield on the US 10-year treasury broke above 5% in October, the highest level since 20072, and many in the market expected yields to remain elevated, views changed toward the end of the year.

Speaking at the most recent Federal Reserve policy meeting in December, Fed chair, Jerome Powell explained that the timing of interest rate cuts was a topic of discussion at the meeting. This admission was taken as an indication that the central bank’s ‘pivot’ has been pulled forward, and saw 10-year treasury yields slump below 4% again3 But, even at this lower ebb, it is important to acknowledge that the calculus for investors has changed.

As Matt Eagan, portfolio manager at Loomis, Sayles & Company points out, the big opportunity now for investors comes from the structure of the bond market itself.

“In this kind of market, you don’t have to take a significant amount of risk to generate a decent return… Unlike a few years ago the yield is your friend. You have a very high yield now embedded in bond portfolios and that itself is going to act as a cushion, it is going to be a source of income and it’s going to be a cushion to volatility that may come your way over the course of the next couple of years,” he said.

Dauchez adds that with real yields so much higher than they have been in years, investors are looking more constructively at 2024 and a strong case is being made for the return of bonds into portfolios.

“Based on the portfolios we analyse, we have seen that many wealth managers are looking at sustainable credit, and extending duration, with government bond funds to be add to their allocations in 2024.”

Where to from here?
For Eagan, the prospects are rosy for active managers. “Over the past 12 months, the market has priced in a downturn within the credit markets even though the economic data hasn’t delivered very bad news at all. So, in a way, you are starting with an above average risk premium, you are seeing a lot of dispersion and very low dollar prices. Those three things are a good definition of a very good bond picking market."

Francois Collet, Deputy CIO at Paris-based DNCA Investments Fixed Income CIO at DNCA agrees that there are plenty of opportunities within the fixed income market now.

“The short end of the curve should be favoured, such as steepeners, especially in the US, while inflation linked bonds still offer great opportunities. They used to be favoured in terms of inflation break evens. Now we tend to buy them in absolute returns in real terms. Emerging debt and currencies should be favoured as well.”

Collet explained that while the firm is also looking to progressively increase exposure to duration, it has no plans to do so quickly.

Turning to the credit sector, Eagan says he believes we are still in the late cycle, but what is noteworthy is that in many ways that market is already pricing in a slowdown or downturn.

“We expect there will be a slowdown and even potentially a mild recession in 2024 but what is important is you are getting paid for that already, so we are leaning in the credit markets predominately investment grade credit in the US and US high yield credit and, particularly in those categories the BBB and BB segments, where we think there are excellent securities selection opportunities in addition to the relatively fat risk premium that you are collecting.”

After decades of low, and in some cases negative yields, investors have begun to grapple with how to build portfolios in a world in which yield has returned. And, for bond investors, that is deeply exciting.
1 Business Insider, April 17, 2022. Bond prices have increased at the same time as bond prices and yields move in opposite directions.
2 CNBC, 23 October 2023
3 Reuters, 15 December 2023

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