11 Dec 2023
Just a few months ago, you had to take great care with bonds in a context of inflation. But now investors should be opting for this asset class, says Stefan Isaacs, Deputy CIO Public Fixed Income at M&G.
For many years, we maintained a defensive position in bonds, with short durations and reduced exposure to interest-rate risk, rates having dropped to zero or even become negative. Yet today our position is the exact opposite. We consider that this investment risk pays well and that it should be given pride of place in portfolios at the expense of shares, real estate and commodities. Investing in corporate bonds means making the most of two dimensions of these securities that have become favourable: the level of long rates and credit spreads. These long rates, as they appear in government bond yields, have rocketed in recent years and months. We can see this as an effect of central banks’ intense actions, but also as a change in perspective on inflation, which was long seen as a passing trend.
Of course, the post-Covid catch-up of consumption and fractured supply chains created an imbalance between supply and demand and gave rise to tension in prices. But from the start of this year, it has become clear that many other structural factors were at play. Among these factors was a vigorous jobs market, both in the US and the eurozone, military spending in an intensified geopolitical context, the cost of the ecological transition, and demographic trends – with an ageing population that might make savings less abundant.
When assessing this situation, the market concluded that the Federal Reserve, the ECB and the Bank of England would probably maintain their key rates at a higher level and for a longer period than planned. Yet though short rates are staying high for longer, bond yields should adjust. Does not a 5-year security yield result from the expected average of short rates over this period?
We think the moment has become favourable for bond investments precisely because we believe that the cycles of tightening are now more or less over. This is especially so given that the rising level of long rates itself helps tighten financial conditions and carries out some of the central banks’ work. But we do not share market expectations that were – only a few weeks ago – banking on aggressive rate reductions from 2024. We believe that the first phases of loosening will not occur until the end of next year at the earliest.
Beyond the attractive level of risk-free rates (around 4.5% in the US and 3–3.5% in the eurozone), the yield excess offered by the credit market increases the benefit of this asset class. It is now possible to enjoy a return of 5% per year by keeping to high-quality investment-category securities in a diversified portfolio – an attractive risk-return ratio, according to us, for European investors, with credit spreads at their historical average. BB-rated firms, which have a historically low chance of bankruptcy, offer 7–8% returns in dollars. This is even the case for bonds issued by multinationals like Ford. Lastly, it is worth remembering the positive effects of inflation on firms, which are most often indebted at fixed rates. Put simply, inflation at 5%, for example, for five years, could reduce their debt by a quarter in real terms.
The information provided should not be considered a recommendation to purchase or sell any particular security. The value of the funds’ assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested . Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.
By Stefan Isaacs
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.