According to ILIM there are now three reasons to consider bonds
By Irish Life Investment Managers | April 15, 2024
Originally published on April 4, 2024
According to Irish Life Investment Manager’s Multi Asset 2024 Strategic Insights report, investors can expect strong returns from bonds in the coming years. Find out why they currently offer an attractive investment opportunity, and how high yields and falling inflation affect this trend. To learn more about the funds sub advised by ILIM, check out these mutual funds and segregated funds.
This article is intended for an advisor audience.
Following several difficult years, and to paraphrase Phil Lynott and Thin Lizzy: ‘The bonds are back in town’! There are now three reasons to consider bonds and it’s about using your H.E.D.:
- High yield levels
- Expectations of yields falling
- Duration
It might not be a hot topic at the dinner table, but exposure to higher duration bonds could provide better offence and defence within multi-asset portfolios.
Coming in from the cold
Bonds currently offer an opportunity for a healthy income stream after the most aggressive monetary tightening cycle in 40 years, with yields now elevated compared to what we’ve experienced on average over the last 10 years. Combined with the potential for capital gains if yields fall, bonds can provide strong returns for investors in the coming years.
The catalysts for lower yields are continued falls in inflation and resultant loosening of the current restrictive monetary policy settings at central banks. Inflation has fallen substantially from at or near double-digit levels in 2022, closer to 3% year over year currently, with expectations to fall further this year towards the Fed’s and the European Central Bank’s (ECB) targets of 2%. Over the medium term, the application of artificial intelligence could also significantly lower inflationary pressures through productivity improvements and potentially contribute to lower bond yields.
Despite the declines in inflation, the Fed and ECB have yet to cut interest rates in this cycle. With inflation expected to continue to fall towards central banks’ targets of 2% during 2024, both the Fed and ECB are highly likely to begin cutting interest rates later this year. This should lead to lower bond yields over the short to medium term. Falling yields would provide capital gains on top of the already attractive income stream available from higher yields.
The case can also be made that significant upside risks for yields could be limited over the coming years. Specifically, the US and the Eurozone are running large fiscal deficits. This means that rates will need to be kept somewhat low to maintain debt sustainability. As a result, ‘financial repression’ may be employed whereby central banks look to cap yields.
Duration rewards
Duration measures the sensitivity of a bond’s price to a given change in yield. The longer the duration of a bond, the bigger the price change is for any given level of yield change.
The maturity of a bond is closely associated with its duration, so that longer maturity bonds tend to have a longer duration. In an environment where yields are falling, longer duration bonds can generate larger price gains and thus provide opportunities for stronger returns in a falling yield backdrop.
Historically, current elevated yield levels have tended to generate strong positive returns over the medium-term in both the Eurozone 5-Year+ and Global Aggregate [DMA13] indices. Starting yields are a good guide for future returns and the current yields are 3.1% and 3.6%, respectively. Strong returns from government bonds are also more likely in the event of a risk off environment.
These bonds have traditionally provided protection as they are seen as safe haven assets. The current higher yield levels provide room for yields to fall if market stress occurs. As a result, within a multi-asset portfolio, the gains from longer duration bonds can more effectively counter any economic weakness and enhance capital preservation.
Buyer demand for bonds is also likely to be supported by liability-driven investment (LDI) strategies, which are heavily used by defined benefit pension plans. The higher yields now available in the market for LDI strategies make it more attractive to increase levels of hedging in portfolios. This invariably means pension plans are adding to their bond positions. Strong equity markets and high yields have also improved funding levels, which has enabled schemes to de-risk where they sell equities and buy bonds. This also pushes up demand for bonds. These factors are likely to provide a structural support for bonds that was absent when yields were very low.
Duration risks
There are some risks to lower bond yields though. In the near term, resilient U.S, activity, ongoing Middle East tensions and associated disruptions in the Red Sea could also add to inflation pressures.
Despite inflation having fallen, risks of inflation remaining sticky or even another uptick are front and centre among central bankers, and this could make them more cautious in relation to cutting rates.
Medium term upside inflation risks remain, amid the emerging trends towards deglobalization and reshoring of supply chains, as well as concerns over security of supplies after Covid, the Ukraine war and increasing global polarization. Demographic trends in numerous countries are also set to reduce labour supply, which could raise workers’ bargaining power and may keep upward pressure on wages and inflation. Decarbonization efforts could also initially add to inflation. Finally, the post-Covid norm of high budget deficits, combined with little appetite for austerity from the electorate, means that governments are likely to continue running large fiscal deficits. Such factors could also keep upward pressure on yields.
Final thoughts
Following the rise in yields in recent years, bonds now once again represent an attractive option for investors. High yields, falling inflation and likely rate cuts in 2024 mean that fixed income assets provide the opportunity for strong returns, offering healthy carry and the potential for capital gains from falling yields. Moreover, the higher rate environment puts bonds in a better position to perform the traditional hedging function in a risk off environment than in the post-great financial crisis period. Extending duration within a multi-asset portfolio at current yields would seem to be a sensible strategy and something investors should seriously consider at this time.
The views expressed in this commentary are those of Irish Life Investment Managers as of April 4, 2024 and are subject to change without notice. This commentary is presented only as a general source of information and is not intended as a solicitation to buy or sell specific investments, nor is it intended to provide tax or legal advice. Although we endeavour to ensure its accuracy and completeness, we assume no responsibility for any reliance upon it.
This document may contain forward-looking information which reflect our or third-party current expectations or forecasts of future events. Forward-looking information is inherently subject to, among other things, risks, uncertainties and assumptions that could cause actual results to differ materially from those expressed herein. These risks, uncertainties and assumptions include, without limitation, general economic, political and market factors, interest and foreign exchange rates, the volatility of equity and capital markets, business competition, technological change, changes in government regulations, changes in tax laws, unexpected judicial or regulatory proceedings and catastrophic events. Please consider these and other factors carefully and not place undue reliance on forward-looking information. The forward-looking information contained herein is current only as of April 4, 2024. There should be no expectation that such information will in all circumstances be updated, supplemented or revised whether as a result of new information, changing circumstances, future events or otherwise.
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