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Thanks to rates reset, bond markets eye a 2024 ‘all about income’: AMP
Following fixed income’s worst year since World War II, and even amid steadily rising yields, a clear message has taken hold of markets in 2023: bonds are back. But lingering risks mean investors should remain discerning, according to AMP, as not all credit instruments will thrive equally in the new paradigm.
In a recent presentation to investors, deputy economist Diana Mousina (pictured, left) and head of fixed income Chris Baker (pictured) described a short-term outlook marked by significant volatility and softer economic growth, with recession chances in Australia still hovering at 50/50. The AMP Investments team expects inflation to fall within the top end of the RBA’s target band by mid-2024, but it’s likely to remain at higher levels than have been the recent norm.
That’s set to prompt a fundamental shift in market dynamics away from equities as the reversion of interest rates to more historically typical levels allows fixed income to resume its core role providing diversification benefits. The income profile is also gaining appeal, with investors now able to capture 6 per cent returns from an investment-grade bond portfolio.
“Next year is going to be all about income,” Baker said. The key for investors will be spotting the winners in the new environment.
‘Sea of green’
While consensus expectations have central banks at or near the peak in their current interest rate cycles, bond yields have continued to surge higher this year, perplexing many commentators. According to Mousina, it’s largely because recession expectations have been pushed out, while stronger-than-expected US Treasury issuance and concerns over the US fiscal situation are adding technical challenges.
But the bottom line is that the move higher in yields is already making bonds fundamentally more attractive. While yield volatility is challenging short and long-term returns, Baker noted, one-year fixed-income returns are now “a sea of green” (see chart).
“Bonds look like a more favourable investment class given that yields are providing a much better income return,” Mousina said, noting that AMP has seen more investors returning to fixed income. “If we do see the risk of that recession play out in the next few years, then we would see some capital appreciation in bonds as well.”
Baker agreed that while upward pressure on yields is negative for bonds, it’s made the starting level of income far more attractive across all sectors. With bond yields and interest rates driving markets, credit has outperformed.
“On a forward-looking basis, we think bonds are far more attractive, and the correlation benefits should return given the reversion we’ve seen in rates, so it should provide diversification in the event of a risk-off environment.”
Equities lose steam
All of this has prompted rockiness in sharemarkets – higher bond yields make equities look less attractive, prompting underperformance in recent months.
That was after a big rebound in July, meaning there’s room for recovery if things don’t escalate, but there are still downside risks to sharemarkets around sticky inflation, slower growth and the chance of recession, Mousina said. This supports having a sizeable share of portfolios in defensive assets like fixed income.
She noted that July saw heightened market exuberance, with excitement around AI reaching extreme levels, so investors may want to wait until sentiment looks “less frothy” to add to equity positions.
With elevated volatility still a key dynamic, markets have been bouncing between two themes, Baker said – how far will bond yields and interest rates will rise, and whether there will be a recession.
“Bond markets have been whipsawed between risk-on and risk-off,” he said. “We’re reverted from the terrible volatility levels of 2022, but it continues to be a challenging environment for fixed income.”
Looking across asset classes against that backdrop, Baker said starting yields are attractive for government bonds and credit, although US Treasuries are not particularly cheap.
“At these levels, there are still clear risks around potential upside to bond yields, so we don’t think this is the time to be going largely long, particularly in the US. In Australia, there are risks given the interest rate sensitivity of our market, and there are some macro risks there that warrant very modest long-duration positioning in the Australian market.”
AMP is still “fairly cautious” on high-risk fixed-income assets, Baker said. “The big question is what will happen to credit spreads if we have an economic slowdown and the impact that will have on high-risk sectors like bank loans and high yield.”
