Interest rates rise. That makes bonds more attractive again – but only if interest rates don’t continue to rise sharply. Bonds appear more stable than stocks in the current market turmoil – but are there other arguments in favor of fixed income investing?
The high price increases, for example for food, forced the central banks to slow down their expansive monetary policy. What does this mean for bond investments?
Many young investors who only came into contact with the financial market in the past decade are hardly familiar with bonds as part of an asset allocation. The class of securities that has always been the safe anchor of a portfolio – and continues to be for insurers and other institutional investors – was often described as “dead”. Steadily falling yields brought profits to bond investments for decades, but institutionally managed portfolios in particular benefited from this. In contrast, rock-bottom interest rates – or even negative ones – made bonds unattractive for private investors compared to the seemingly endlessly booming stock market.
Bonds offer advantages that other investments do not have. When buying a bond, the investor knows what the interest rate is and when the bond will be repaid. In the case of high-quality borrowers, especially government bonds, default is practically impossible. The value of bonds can fluctuate over the term: if interest rates rise, the price of the bond falls and vice versa. However, if the fixed-income investments are held until repayment, the investor receives the nominal value back. This stability alone makes the bond segment attractive again when the stock market threatens to lose ground.
The ECB is also turning around
However, the wind has turned on interest rates in recent months. Inflation has returned in recent months at rates not seen in decades. Soaring inflation rates would actually require more aggressive rate hikes, but a much weaker economy warrants a more moderate approach. But after the central banks gave priority to economic development for a long time, the focus is now on containing inflation. In the US, the Federal Reserve has ended the ultra-expansive monetary policy that had been applied for years. The European Central Bank also moved last week. On July 1st, net asset purchases will end and the cycle of rate hikes is set to begin.
At first glance, bonds that pay higher yields appear to offer entry opportunities for investors. Finally, the bond issuers have to compensate their creditors more appropriately again. But when interest rates rise, the value and yield of bonds already issued on the market fall. Anyone who invests in bonds today while interest rates continue to rise would also be affected by this drop in value.
“The sudden countermeasures in monetary policy have triggered a tsunami on the bond markets,” says Harald Preissler, who, as Vice President of the Board of Directors, is responsible for the strategic development of the asset manager Bantleon. Within a year, interest rates shot up more than they had in over 20 years. The yield on the Swiss “Confederates” with a term of ten years has climbed from minus 0.4 percent to around 1 percent since last August. If the Swiss National Bank reacts to the ECB’s tightening of monetary policy, a further rise in yields is likely to follow.
Safe havens shake violently
The yield on ten-year German government bonds jumped from minus 0.6 percent to around 1.4 percent, while the yields on their counterparts in the USA even climbed from 0.5 percent to over 3 percent. In this environment, global government bonds experienced their sharpest price slump in the past 50 years. “Despite the geopolitical uncertainty, investors did not look for classic safe havens such as US government bonds in the first few months of the year, but mainly avoided them,” says Ann-Katrin Petersen, capital market strategist for Black Rock.
“It’s a toxic environment for government bonds,” admits Guillermo Felices, investment strategist at PGIM Fixed Income. But the US and German bond markets would be pricing in a lot of bad news on the inflation side. In the case of the euro zone, this inflation is part of a stagflationary energy shock that will affect growth in the future, so that interest rates have trended downwards asymmetrically. In the case of the USA, according to Felices, the Fed may have to tighten monetary policy more, as this inflation shock is amplified by an overheated economy, in contrast to the euro zone.
According to Preissler, quite a few investors draw the conclusion that bonds are a toxic or – even worse – a dead asset class that no longer deserves a place in a multi-asset portfolio. This is all the more true when you look at real returns, i.e. those after deducting increased inflation. For this reason, the investment focus should be placed even more on equities in the future, because with an expected average performance of 7 percent, they could also score points against permanently higher inflation. “That sounds good, but it’s a milkmaid’s calculation,” says the Bantleon manager. Even if the unfavorable environment for bonds persists, it will not make bonds obsolete. The asset class has already come through the toughest part of the journey on its arduous journey back to normality.
Is the recession coming or not?
“A large part of the expected rate hikes should now be included in the prices,” says Richard Mooser, Chief Investment Officer at Axa Investment Managers. However, it could hardly be wrong to wait a little longer until further developments, especially on the “inflation front”, can be better assessed. “Bond default rates remain very low, although the environment is expected to deteriorate as the cycle progresses,” said Yannik Zufferey, head of fixed income at Lombard Odier Investment Managers (LOIM). Also, spread levels would already factor in a sharp deterioration, which should be an interesting opportunity in the medium term if you can live with increased volatility. LOIM’s analysis shows that higher quality credit and government bonds have outperformed stocks in both recessionary downturns since 1983.
Various economic indicators in the USA and Europe are signaling stabilization and thus a continued low risk of recession. This is confirmed by the rather steep yield curves in the range between three months and ten years. Historically, a recession has always been preceded by a full flattening or even an inversion—i.e. In other words, long-term interest rates on the capital market were lower than short-term ones. The real interest rates (key interest rates minus the inflation rate) are currently still low or even negative. This has a strong supportive effect on the economy and the stock markets. From September, however, there is a risk of a significant deterioration in the USA, for example.
Until then, key interest rates will continue to rise and inflation rates should be significantly lower, leading to a rise in real interest rates. If the stock and credit markets develop positively in the coming weeks, but at the same time interest rates rise and liquidity is reduced by the central banks (balance sheet reduction), there is a risk of a development similar to that observed in 1987. At that time, rising valuations on the stock exchanges and balance sheet reductions as well as a more restrictive monetary policy by the central banks led to a temporary market correction – without a recession developing.
When inflation falls again. . .
“In the short term, given the already pronounced repricing of monetary policy expectations, the potential for price setbacks in core government bonds seems limited,” says Petersen. The central banks on both sides of the Atlantic would quickly normalize their monetary policy, but they would not put the brakes on economic activity. According to the Blackrock strategist, the inflation dynamic is mainly due to supply shortages and is therefore only within the central banks’ direct sphere of influence to a limited extent. It is therefore quite conceivable that the US Federal Reserve will take a breather in the coming year in order to determine the effect of its tighter interest rate and balance sheet policy on the real economy. For investors with a short to medium-term orientation, short-dated US bonds, for example, could be of interest, as a kind of ballast or buffer, says Petersen.
“The sometimes massive rise in interest rates is solely due to the sharp rise in inflation figures,” says Mooser. If there were any signs that inflation had peaked or even passed, yields would also begin to fall again. “The elevated yield levels are attractive to medium-term investors if you’re able to weather some volatility,” says Zufferey. Fixed income markets would remain volatile over the coming months. Over the medium term (over 3 to 5 years), LOIM expects investment grade Euro bonds to return 3 percent and US equivalent quality bonds as much as 5 percent.
According to Mooser, if you want to get started now, there are various fund solutions that are as broadly diversified as possible. For the somewhat more experienced private investor, a selection of individual stocks in the medium investment grade range, with maturities of five to seven years, can also lead to net positive nominal returns.
Diversify actively or passively?
Passive funds that map an index (ETF) are advertised as simple and broadly diversified investment instruments for inexperienced investors. However, bond ETFs cover the entire market and are therefore most heavily invested in the most heavily indebted issuers. Since the beginning of the year, most bond ETFs have performed disappointingly. But Salim Ramji, Blackrock’s head of index investments, argues: “Bond ETFs have proven to be resilient investment vehicles in a variety of market conditions, including near-zero interest rates, pandemic-related market stress and inflationary pressures.” These ETFs have survived many tests and become the catalyst for a more modern, digital and transparent bond market.
“Despite the slightly higher costs, actively managed fund vehicles are now more recommended than ETFs,” says Mooser. Especially since an actively managed portfolio has a clear advantage over a passive product in an environment of massively increased volatility. The difference in costs is rather small – especially since the nominal yields would again have a reasonably positive impact.
On the other hand, according to Preissler, equities will continue to lose their return potential: Prices are still above average in relation to profits, with rising returns future company profits discounted to the present would lose value, and profit margins are likely to be under pressure in the long term devices. This not only has to do with structurally increasing raw material and pre-material costs. Labor is also becoming more expensive due to the unfavorable demographic environment.