With interest rates set to tumble, top-quality bonds of longer duration make sense
By Pictet Wealth Management CIO Office and Macro Research.
In today’s market environment, we see merit in being ready to move away from cash and into quality fixed-income investments to capture the appealing yields we expect them to offer during the course of the year. Those yields should be weighed against the uncertainties involved in equity investments, and also considering that high yields may not last: central banks are expected to lower interest rates in the year ahead.
In 2020, advanced economies began contracting quickly and drastically. Governments and central banks responded with stimulus programmes in 2020 and 2021 to support businesses and households. This involved pushing interest rates down to extremely low levels. In some cases, deposit interest rates went below zero. These measures helped relieve hardship and ensure the contraction was short-lived. In fact, a recovery already began in 2020 and proved to be stronger and faster than initial projections. As conditions improved, corporates and governments were encouraged to take our debt to avail of the ultra-low interest rates.
Moreover, as debt-fuelled government spending flowed into the economy, inflation took off. This was exacerbated by supply chain disruptions, a scarcity of labour as many workers withdrew from the jobs market, trade tensions and the rising cost of energy – so-called “supply side” factors that combined to push up prices.
The extent and duration of the price rises surprised central banks. The US Federal Reserve said in 2021 it expected the higher-than-normal inflation rate to be “transitory”. But as US inflation surged up to a 40-year high in 2022, the Fed and other major central banks began ratcheting up interest rates – their main tool for controlling price pressures. The higher policy rates have pushed up the cost of servicing debt. They have also fed through into higher yields on bonds, both sovereign and corporate. In other words, bond issuers are having to offer higher yields on their debt to entice investors.
As central banks continued to hike their policy rates in 2023, fixed-income investors rushed into low-duration, risk-free money-market instruments, especially as short-term yields remained higher than longer-term ones. Up until recently, lingering doubts about longer-dated debt—and the thought that interest rates would stabilise–ensured that funds continued to be poured into money-market funds. Now, however, markets are increasingly pricing in cuts to short-term policy rates over the next year as inflation ebbs and economies slow. The return on cash and cash-like instruments is therefore sent to sink and the ‘opportunity cost’ (the cost of not mobilizing cash for other investments) is set to rise.
Yields are still interesting on top-quality bonds such as those issued by governments and corporates with high credit ratings.
Yields are still interesting on top-quality bonds such as those issued by governments and corporates with high credit ratings. These offer good fundamental value in return for reduced risk. But falling yields mean that high-quality bonds are already becoming more expensive. Given the return potential relative to risk and given that the drop in inflation is making real (post-inflation) yields look more appealing, bonds of longer duration may be considered.
Three characteristics of bonds are important for investors to watch:
- The coupon. This is interest paid to bondholders, normally annually or semi-annually. Coupons are attractive while policy interest rates are still high.
- The stability of the price. Bonds have an inverse relationship to interest rates. So, when interest rates fall, bond prices usually rise. This is because bonds pay a fixed rate of interest that becomes more attractive if interest rates fall, driving up demand and the price of the bond.
- The quality of the bond. Quality bonds are usually subject to less price volatility. So while higher yielding bonds may offer more yield, in today’s challenging economic environment their issuers are at greater risk of failure and default. Investment grade bonds – those rated from AAA to BBB by rating agencies – are safer bonds with low risk. This means they are unlikely to default and tend to remain stable investments. Yields on investment grade bonds are appealing.
Moving to fixed income means locking in yields that are still appealing. The decent coupons offered by bonds buffer investors’ capital, providing their portfolios with a cushion against any adverse movements in market prices. The risks associated with the highest-quality bonds are low. This is an important consideration during periods of market volatility and geopolitical instability.
