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Is it time to invest in bonds?

4 months ago

Niall McDonnell, Senior Investment Manager

Niall McDonnell,
Senior Investment Manager, Architas

Is it time to invest in bonds?

Bond investors have been in for a rough ride over the past couple of years, with 2022 the second consecutive year of negative returns for holders of fixed income securities. Yet the protracted sell-off could now mean that bonds are looking attractive again. They might even be ready to resume their traditional role of offering both income and diversification. Is it time to look at bonds again?

Central banks caught napping

Inflation started to tick up gradually towards the end of 2021. As the global economy recovered from the pandemic, consumers began to spend the cash they had been hoarding during lockdowns. As demand rose so did prices, partly due to supply chain disruptions and labour shortages. Central banks acknowledged these price pressures at the time, but said they expected these effects to be temporary.

Russia’s invasion of Ukraine in early 2022 changed the narrative, adding fuel to the inflationary fire by causing the largest commodity price shock since the 1970s. Inflation surged but central banks were slow to respond, hesitating to raise rates while the economic outlook was so uncertain. While the UK was the first G7 nation to raise rates in December 2021, it took another three months before the US Federal Reserve (Fed) started to tighten monetary policy and the European Central Bank waited until July 2022 before acting. But once rates had started to rise they did so very quickly, as central banks scrambled to get ‘ahead of the curve’ and dampen future inflation expectations.

The end of an era

Bond prices needed to adjust to the ending of ultra-low borrowing costs, meaning negative bond yields were unlikely to be sustainable over the long term. But it was the speed of interest rate hikes that caught investors by surprise. In the US, the Fed hiked rates by 375 basis points between March and November, making this one of the most aggressive rate hiking cycles on record. Bond prices fell, as their yields rose to reflect rising interest rate expectations.

And it’s not just the bond markets that sold off. Equity markets were also unnerved by the speed at which borrowing costs were rising. This is particularly true for growth-orientated companies, many of which have only operated in an era of ultra-low interest rates. They now have to adjust to a business model where the value of their future earnings is undermined by higher rates. This simultaneous decline in both bond and equity prices is unusual as the two asset classes are generally negatively correlated, meaning one goes up when the other falls.

Time for bonds to shine?

The steep sell-off in bonds in 2022 has been universal, with little differentiation between sectors and quality. This could be a golden opportunity to invest in the assets which have attractive valuations and strong fundamentals. In the US, the yield on the 10-year Treasury bond touched a peak of more than 4.2% in mid-October. That’s an increase of around 325 basis points compared to yields at the start of 2021 and the highest level since 2007. Credit markets have also been hit hard, with yields returning to levels last seen during the height of the pandemic, as prices fell. In October, the yield on the US high-yield bond market reached 9.5% while European high-yield bond yields exceeded 8.0%.

In recent weeks, the increase in consumer and factory gate prices has started to ease, sparking hopes that we might have seen peak inflation. The Fed has signalled that it is now likely to reduce the pace at which it raises rates, although Fed chair Jay Powell stated that rates will likely need to be ‘higher for longer’ to bring inflation back to target of 2%. Even though rates are yet to fall, investors will look beyond current news and start to anticipate future developments well ahead of time. Once they do, there could be a significant reversal in fortunes for bonds.

Architas view

Our view

After years of ultra-low or negative yields, bonds have now priced in significant increases in interest rates. That has pushed yields back up to attractive levels, meaning bonds can once again appeal to income-seeking investors, although diversification remains important to help spread credit risk. As part of a multi-asset portfolio, bonds are also well placed to offer a hedge against a severe sell-off in equities. A steep recession could weigh on equity prices, but it would also help to tame inflation, placing downward pressure on bond yields and allowing bond prices to rise.

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