Few questions preoccupy investors' minds more right now than the direction of interest rates.
Most fixed income assets rose steeply in the final quarter of 2023 as investors began to price in a series of cuts to base rates being implemented by, respectively, the US Federal Reserve, the European Central Bank and the Bank of England.
In particular, market participants rushed to buy bonds with a longer date to maturity and high-yield bonds.
Falling base rates make longer-dated bonds relatively more attractive as investors seek to lock in today’s higher yields for the maximum possible time, as lower base rates will drive down the yields on bonds issued in future.
High-yield bond prices tend to rise when markets expect rate cuts because investors with income as a priority move to the highest-yielding part of the fixed income universe, as they anticipate yields falling in the lower risk areas.
The second reason high-yield bonds tend to do well when rates are falling is that rate cuts are designed to stimulate economic activity, and increased economic activity raises the likelihood that the company or country will be able to repay the debt.
But while markets reacted rapidly to price in rate cuts, since the start of 2024 there has been a reassessment of the outlook for monetary policy, with central banks signalling caution on the timing and extent to which monetary policy is loosened.
Amid such uncertainty, how can fixed income allocation be positioned for returns in the coming years?
Pimco economist Nicola Mai says: “Looking ahead, in our baseline scenario (where we envisage both growth and inflation slowing), bond yields will likely be anchored. But if you have a deep recession, bonds are likely to outperform – and may perform better than equities.
"Finally, if we experience a “sticky inflation” scenario, that will hurt bonds as well as equities; however, equities will get hurt by the tighter monetary policy expectations, whereas with bonds investors still have the coupons to cover some of these losses.”
Amundi investment manager Jacques Keller tells FT Adviser the market is essentially divided into two types of investors right now.
He says: “In one corner of the market, you have money market investors enjoying high yields but increasingly concerned about their re-investment risk. In the other corner, you have long-duration investors dealing with rate volatility and the inverted term structure of rates. Admittedly, the latter has lower re-investment risk.
"We believe a diversified allocation to short to intermediate bonds should be part of the solution.”
Keller says the risk for the investors holding cash and very short-dated bonds is that as they mature, the new rates offered will be lower than the current rates, altering the investment case for that part of the market.
