Commentary: Yields attractive, return uplift forecast ahead

2023 has thus far been a choppy year for bonds. The year started with yields at attractive levels, and largely bonds have earned their income as prices have gyrated, leaving yields now at about the same level as they started. Inflation remains uncomfortably high, which has seen developed economy central banks continue to tighten, pushing yield curves materially flatter as longer term yields have remained largely anchored. Meanwhile, better than expected growth data has seen credit spreads narrow (and other risky assets rally) in spite of tighter policy.

Coming into this year we firmly believed high-quality fixed income offered attractive relative and absolute value. We also expected the economic cycle to turn in favour of bonds - as headline inflation softens with supply chains normalising, as growth weakens with rate hikes and cost pressures biting, and as central banks complete their aggressive tightening.

Waiting for the bite

The predicted turn in the cycle is clearly taking longer to materialise than anticipated. In part, this is simply because it takes time for policy tightening to bite. Common estimates are that rate hikes don’t fully impact for 12-18months – suggesting they won’t truly be felt until later this year. We also expect central banks still have a bit more work to do - in Australia, we anticipate the RBA will need to hike a further two times.

In spite of higher interest and general living costs, consumers have remained surprisingly resilient. Buffers built up during Covid have proved effective (to date) in offsetting some of the ongoing real income squeeze, and some relief for wage earners is now in sight with wage rises on the horizon in Australia, amid an ongoing tight labour market. Housing markets have also stabilised earlier than expected, in Australia partly driven by a firm rebound in migration. Strong competition may actually see a relaxation of home lending conditions in Australia, in contrast to the ongoing tightening of credit supply expected in the US and Europe.

Profitability & growth holding up

Meanwhile, in spite of higher input costs and reduced sales volumes, corporate profitability (in aggregate) is also holding up better than expected, in turn supporting labour markets. In general, corporates have been able to pass higher costs through, albeit that there are specific sectoral winners (eg utilities) and losers (eg discretionary retailers).

Growth holding up, in spite of inflation, has also proved greatly beneficial for asset allocators, as this has supported returns in riskier assets, sending bond-equity correlations back to negative this year. This supports the idea in fixed income portfolios to again pair duration exposure with income generating assets.

Albeit that the consumer and business spending slowdown is taking longer to materialise than predicted, the balance of risks continues to move towards slowing growth and moderating inflation. High quality fixed income is poised to do well relative to other assets, particularly should downside risks gather speed. Higher than comfortable core inflation likely increases downside growth risk as central banks maintain their focus on fighting inflation, meaning rate cuts are unlikely this year and leaving riskier assets vulnerable. Bonds should again fulfil their role as cyclical diversifiers.

Positioning

Drawing together our key research inputs, our key views remain little changed. Now is the time to consider:

• in the countries where central banks have tightened most aggressively / where inflation is showing best evidence of softening (e.g. the US) and in markets which have greater sensitivity to interest rates (e.g. Australia). Within these markets, short dated bonds should do relatively better than longer dated, once rates peak.

• 67% of the portfolio is allocated to issuers rated AA and better, mostly via our government, semi-government and supranational allocations. Within credit allocations, we prefer investment grade. The high quality of Australia’s investment grade credit market, its short tenor, and relatively wide spread make it particularly appealing to us versus other corporate bond markets. We have been able to access good yield in this way, while minimising our exposure to riskier credit.
• within our Australian credit allocations we have been buying banks from an underweight position, and de-risking by reducing lower rated corporate issuers. We believe that Australian banks are well positioned, with simpler business models than global peers, high liquidity and robust capital levels.
• providing greater flexibility to position actively. We expect market volatility to remain high as we come to the forecast turn in the cycle. We expect to use this volatility to continue to accumulate interest rate duration and spread assets at attractive levels.

High-quality fixed income can offer attractive income levels and improved diversification benefits as the cycle turns. We believe asset allocators should consider a rebalance back in favour of fixed income.

For more insights on our fund positioning and performance this quater, watch the video below from Kellie Wood, Deputy Head of Fixed Income at Schroders.

Learn more about the Schroder Fixed Income Fund.