By Richard Flax, Chief Investment Officer at Moneyfarm
After enduring the impact of a dramatic rise in interest rates, the combination of higher coupons and a loosening of monetary policy could finally favour bonds, which have yet to experience a true rebound from a dreadful 2022. Last year, the continuous upward pressure on interest rates (unexpected by many) led this asset class to underperform. Only the repositioning of monetary policy in the last part of the year brought positive results in the last quarter. And 2024 has so far also proven a challenge. If we accept that policy rates have likely peaked, the trajectory from here – the pace and extent of interest rate cuts – is proving tricky to assess. Hopes for a swift decline in policy rates have been tempered in recent weeks by only modest improvements on inflation and resilient economic growth, particularly in the US.
Without getting too caught up in stories heralding a new era for bonds, higher starting yields do help to give bonds a renewed relevance within a diversified investment strategy.
What can we expect then in the short and long term?
Let’s start with the long term. In theory, equilibrium interest rates should be more or less in line with nominal GDP growth. In this sense, looking at the next five years, just taking estimates from the World Economic Outlook, rates should remain high, in line with nominal growth. That should give long-term investors some comfort that the asset class has the potential to produce higher returns in the coming years than it did in the previous 10 years.
In the short term, bond performance will be influenced by interest rate dynamics. Market expectations have moved around a lot in recent weeks – as some of the optimism about rate cuts has ebbed away. Nonetheless, we do expect to see policy rates come down over the course of 2024.
An easing of monetary policy dynamics should bring greater stability to the bond market, but clearly, what will matter is how reality unfolds compared to expectations regarding interest rate dynamics. If expectations were to be revised in a restrictive sense, rates could partially rise. Shorter maturities (up to two years) would be less affected, while longer maturities are more exposed to the effects of interest rates.
For this reason, the shorter end of the curve remains interesting, with the rate level still offering an attractive risk-return profile. On the other hand, longer-term bonds, after the excellent performance in November and December, entail additional risks, especially considering that yield curves remain inverted – investors are paid ‘less’ to lend money for longer periods.
In short, we believe that current yields are attractive, but bond investment is not without risks and challenges. Long-term expected returns, based on our estimates are at their highest levels in some time, which is good news for those investing with a long-term perspective within a diversified strategy. On average, the longer end of the curve for developed countries does not seem to promise extra returns compared to the less risky short end. Credit has an interesting dynamic. Absolute yields are higher than they have been for some time, but the additional yield (spread) compared to less risky government bonds is not particularly high versus history.
Are we looking at a new era in bonds?
Some investors are so enthusiastic about the prospects of this asset class that they argue that their entire portfolio should be repositioned according to the bond component. However, rather than a new era, the interest rate context represents a “new normal”, with positive levels finally able to compensate investors’ risk.
