The sharp rise in global bond yields since early 2022 has boosted the attractiveness for fixed income assets, but the key question facing investors is has the fixed income boat already sailed?
After a decade of ultra-loose monetary conditions that suppressed yields and reduced the effectiveness of bonds to diversify portfolios - the case for fixed income assets seems to be ironclad. Rising interest rates have boosted the income they offer with yields in many sectors at multi-year highs.
Take high yield debt, for example. With global and European high yield debt yields near decade-highs, they represent good value for investors to lock in an attractive yield. History shows investors with a one- to- two-year time horizon can reasonably expect to earn double digits returns if they invest at current levels.
However, climbing bond yields are set against a backdrop of storm clouds darkening the economic landscape.
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Manufacturing surveys across the world are mired in recessionary territory while services, one of the few bright spots in the global economy, is losing momentum as consumer balance sheets start to feel the heat from the lagged effects of the aggressive monetary policy tightening campaigns by major central banks. Even China's much-awaited post-Covid economic recovery has fizzled.
Furthermore, central banks are straying into the realm of policy errors in their quest to quell inflation, as restrictive monetary policies threaten to tip their economies into recession. Meanwhile, the removal of liquidity from the global financial system, that caused turbulence in UK pension funds and US regional banks, could unearth further shaky debt structures and hidden leverage in obscure corners of the market.
The right shelter
While storm clouds may be rolling in, not all boats will sink, and those with ballast can provide shelter for investors. A focus on stock selection is imperative.
Global high yield bonds provide an opportunity to generate value amid choppy waters, given robust fundamentals. Valuations have improved considerably, while capital structures are robust, and the asset class is higher quality than in the past. Many companies refinanced during the pandemic and secured low-cost funding, so balance sheets are healthy. While defaults will likely go higher, we are unlikely to see the levels reached during the Global Financial Crisis. Stock selection will be key, but if you are in the right boat, you can catch some decent returns.
Emerging market debt also looks appealing, given a growth premium over developed economies, alongside attractive yields and cheap currencies. Many central banks in these countries were proactive to address inflation concerns - Brazil's central bank first raised rates in March 2021, long before the Fed, hiking more than ten times to lift the Selic rate to 13.75%. Indeed, some are now poised to cut rates, while developed central banks such as the Bank of England need to deliver more rate hikes to combat sticky inflation.
While rising global borrowing costs could hurt some frontier economies dependent on foreign currency loans, emerging markets are more resilient than in the past - with healthy balance sheets and strong fiscal buffers. India and Indonesia are bright spots, with stronger adherence to monetary and fiscal frameworks, while also benefiting from domestic consumption and the green energy transition, respectively.
Beware, inversion ahead
An aggressive shift into bonds might be risky though, especially given the shifting tides as we transition from a late-cycle economic expansion to a potential recession scenario. Yield curves are inverted and extending duration too soon could be costly.
While central banks have signalled they are nearing the end of one of the most aggressive monetary tightening cycles in recent history, they have also pushed back against market expectations of rate cuts in the near term, given resilient labour markets.
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Even the ultra-dovish Bank of Japan eased its grip on government bond markets in late July, allowing a wider trading band in its yield curve control. As markets digest implications of the latest policy tweak, Japanese bond yields are likely headed higher as inflation remains above target.
The cost of investing in bonds using borrowed short-term money to finance long bond positions means sacrificing yield daily - with shorter-dated bonds offering higher yields than longer-dated maturities.
Source of diversification
Whether an economic downturn materialises or not, bonds are once again reasserting themselves as a diversifier in portfolios. For those wary of taking equity risk, high yield bonds look cheap relative to stocks and are shorter duration than core bonds. Our asset allocation team holds an overweight view on credit - both high yield and emerging market debt.
Dispersion in monetary policy cycles offers a fertile ground for bond investors with an active mindset. Taking a global approach provides opportunities in markets with steeper curves and positive slopes.
We are also long Treasuries. While cash is king at current yields and earns you a better carry, Treasuries are a better hedge if we do get a recession.
Starting to add some duration can also provide valuable diversification amid the changing tide.
Ritu Vohora is an investment specialist at T. Rowe Price
