Transcript: Bonds offer attractive combo of returns and diversification

On bond yields

JD: Fixed-income markets rallied really strongly into the end of last year, as expectations built around a soft landing and easier policy stances among developed market central banks. Stepping into this year, however, we’ve seen bond markets give back some of those gains as yields have risen. While there are some risks of further increases in yields, we would suggest that these are limited by reduced risks of central bank rate hikes and the fact that growth forecasts, while they’re being revised upwards, it’s not to the same extent as last year. So ultimately, we would look at the backup in yields this year as a reassessment around the timing of rate cuts, as opposed to a fundamental shift in the direction of travel.

The prospect of capital gains

JD: We expect that U.S. 10-year Treasury yield to fall by approximately 100 basis points from current levels on a 12-month view. Longer-duration fixed-income assets should benefit from a fall in yield backdrop to the greatest extent. If we do a quick back-of-the-envelope calculation on this, a 100-basis point drop in rates on a fixed-income position with a duration of in and around 10 years, for example, should translate into a double-digit return. This combines both carry and capital gains. If we were to see economic weakness come through, with concerns around growth, or potentially a recession, you could expect higher returns as yields fall further. An important point I would add here, though, is that it’s no longer necessary for yields to fall in order for government bonds to deliver a return. With the 10-year Canadian government bond yield trading at close to 3.5%, even if yields don’t fall from here, you can still earn a return.

Offensive and defensive possibilities

JD: The landscape has fundamentally changed with the increases in yield we’ve seen from the middle of 2021. We’re in a very different environment now, with yields having moved significantly higher. Typically, prevailing yields are a reasonably good indicator of future returns over the medium to long term. And this suggests that current market pricing is consistent with attractive return potential going forward. This is further enhanced by our view that interest rates will fall from here, and that should provide a powerful tailwind in terms of capital gains. So in other words, you know, bonds are now offering a very attractive combination of both return opportunity and diversification potential.

Wider opportunities

JD: While we are certainly constructive on higher-quality, fixed-income assets, if we cast the net a little more broadly, we’re also seeing opportunities in the riskier higher-growth portions of [the] fixed-income market, particularly in areas like high-yield bonds, and emerging market debt. Within high yield, all-in yields are attractive at around 7%. And while spreads are somewhat tight, it’s important to note that credit quality in this area has improved. If we look at hard currency emerging market debt, we’re similarly seeing attractive valuations with yields currently trading at around 7.5%. If we look at local currency emerging market debt, while yields are not quite as high here at just under 6.5%, this is still a yield level that’s consistent with attractive return potential.

And finally, what’s the bottom line on fixed-income investing in the current moment?

JD: High-quality fixed-income assets look attractive on both a stand-alone basis as well as in the context of a broader multi-asset portfolio. Yields are back at more attractive levels. [That] provides a beneficial entry point for investors. While the potential for lower yields going forward should benefit longer-duration positions, particularly relative to cash whose returns would be hurt by falling rates. All of this is coupled with our expectation for bonds to move back into that diversifying role versus the portfolio’s risk assets like equities. So when we take these pieces together, bonds can be a very powerful tool in investor portfolios. If I was to try and encapsulate all of this into a snappy title. I’d say, ‘Bonds are back!’

Well, those are today’s Soundbites, brought to you by Investment Executive and powered by Canada Life. Our thanks again to Jack Delaney of Irish Life Investment Managers. Visit us at investmentexecutive.com where you can sign up for our a.m. newsletter and never miss another Soundbite. Thanks for listening.

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