Bonds are back – here's how to navigate the market

‘Interesting’ can be a word packed with subtle menace, especially when used by investors dealing in what are traditionally sleepier assets. It’s a term that has received plenty of use among fixed-income investors in the past year, although in this case the implications have been positive as well as negative.

Bonds sold off heavily last year in a period marked by inflation and rising rates, with the likes of government debt particularly hard hit. The silver lining, of course, came in the form of much higher yields and lower prices, offering some form of compensation and more attractive entry points for both growth and income investors.

The broad market rally that characterised the opening months of 2023 certainly reinforced the case for jumping back into bonds: the first quarter of the year alone saw funds focused on sterling bonds make some outsized gains in the context of what is normally a slow and steady asset class. The average fund in the Investment Association (IA) UK Index Linked Gilts sector was up by 5.3 per cent, with the Sterling High Yield and Sterling Corporate Bond sectors each up by around 2.3 per cent, a return roughly matched by the UK Gilts peer group.

With the horrific losses of 2022 in the rearview mirror, yields offering a reason to stick with the asset class and interest rate rises tipped to peak in the near future, bonds had started a long journey to recovery.

But one problem with calling a recovery is that you can be too early in doing so – and bonds have certainly faced a few setbacks more recently. UK investors attracted by the higher bond yields on offer for much of 2022 ran into a fierce renewed sell-off in gilts last September on the back of the failed mini-Budget. While the latest sell-off hasn’t rivalled that episode in severity, fixed-income fans have again run into problems in recent weeks. Stickier-than-expected inflation and the prospect of economic troubles pose problems for certain subsectors of the asset class, and mean there could be big winners and losers among them. Whatever happens, bargain hunters may need a good level of patience.

High yield – still leading the pack?

Although Germany, for one, has officially fallen into recession, fears of a brutal and widespread global economic slowdown have yet to come true for now. That relative strength has helped high-yield credit, the riskier segment of the corporate debt market, which tends to perform well when companies are in decent shape and less likely to default on their loans. High-yield bonds have tended to offer greater levels of risk and reward compared with the likes of government bonds, although as the events of 2022 illustrate this may not always be the case.

Recent developments have at least pointed to a good level of confidence in the high-yield sector. George Curtis, portfolio manager at bond specialist TwentyFour Asset Management, noted in a blog post from late April that issuance of high-yield debt had enjoyed a brief revival at the time of publication. “The high-yield primary market lay dormant for much of 2022 and the first few months of 2023 as recession talk and significantly higher yields led most companies to pause any issuance plans,” he said. “The past few weeks, however, have seen a resumption of issuance, with issuers using the recent outperformance of high yield compared with investment-grade credit, and a strong technical backdrop (limited supply, large cash balance) to refinance and/or bolster cash balances.”

Curtis noted at the time that his team had used such sentiment to in fact take profits on high-yield debt, given that the ‘spread’, or difference in yield on offer from such instruments versus government bonds has been reasonably tight – suggesting high-yield is expensive. However, he did concede that issuers’ strong balance sheets and limited refinancing needs could support an “optimistic view” on the risk of high-yield borrowers defaulting on their debt. A note published by Curtis’ colleague Danny Zaid on 17 May, analysing the latest US earnings season, seems to back this view. Zaid noted that, with 92 per cent of S&P 500 companies having released earnings updates at the time, 78 per cent had beaten expectations, a level that beats the 10-year average of 73 per cent. It also made for the highest percentage of S&P 500 companies unveiling a positive earnings per share (EPS) surprise since the third quarter of 2021 – admittedly against a backdrop of pretty tepid expectations from analysts, who had slashed their forecasts ahead of time.

Even more relevant is the performance of the US high-yield credit market in the same period. More than half of US high-yield issuers reported Ebitda ahead of expectations, compared with 14 per cent missing guidance. JPMorgan analysis, meanwhile, shows 80 per cent of high-yield issuers in the firm’s US universe giving either positive or neutral guidance on a forward-looking basis. Zaid also pointed to the fact that, while technology companies in the high-yield sector had a more pessimistic outlook, guidance from “old economy” sectors was much stronger. With the US high-yield bond universe having much less exposure to tech names than the country’s equity market, one could serve as a useful offset to the other.

High-yield is the riskier end of the bond market, but some might argue it does serve as a safer (albeit lower reward) exposure compared with backing equities for those who seek some limited level of diversification. The main unknown relates to whether market optimism proves overdone, and whether economic hardships will send high-yield bonds into a tailspin. Cautious investors can certainly see the case for easing up on high-yield exposure: the team behind Jupiter Strategic Bond (GB00B4T6SD53), the biggest of the flexible bond funds available to UK retail investors, has been doing just that while upping exposure to government debt. Ariel Bezalel, the best-known member of that team, warned in a presentation at the end of May that inflation was “more last year’s concern”, and that investors should instead worry that a lack of economic growth could come to bite. With credit spreads not pricing in a “sharp deterioration” in the global economy, hard times could be ahead for riskier bonds. Bezalel also pointed to a recent spike in corporate bankruptcy filings in the US, and the fact that company liquidations in the UK had risen above their pre-pandemic level, as possible gloomy indicators.

It's worth adding that bond fund managers can be more alert to potential risks than their equity counterparts – but also that Bezalel’s team has tended to err on the side of caution in the past with a keen eye for possible threats. In any case, risk-averse investors might wish not to up the ante within their bond allocations if they already worry about what lies ahead.

Anything risk-free?

The sell-off that dominated the bond universe in 2022, and the turbulence that ripped through the UK government bond market in particular after the mini-Budget, seemed to justify the fears of many that high fixed-income prices were destined to collapse at some point. And yet there is no knowing whether we have reached the bottom just yet: the higher-than-expected UK inflation figure published in late May prompted gilt yields to hit levels not seen since last autumn's woes. As the chart shows, that put a dent in the gains made in the year to date by funds focused on government debt, and once again raised questions about what exactly a 'risk-free' asset is.

Thankfully, this debate about government debt does seem simpler to weigh up than questions over riskier corporate debt. Recent fears about the US government debt ceiling being breached aside, bonds issued by developed countries should remain safe – meaning investors who bought in for the relatively high yields need to simply grit their teeth through any further sell-offs prompted by higher inflation readings or a longer than expected bout of interest rate increases. The reasonably high yields on government bonds also provide them with room to fall – and for prices to rise – if a recession does kick in, or if equity investors seek out safe-haven assets for some other reason.

As we have previously discussed, bond investing in general nowadays requires long-term time horizons, with investors taking a decent yield in return for staying invested, rather than simply hoping prices will continue to rise as in the days of quantitative easing. That trade-off, while it will be attractive to many, may require a new mindset from the typical fixed-income investor of the past decade.