Playing a defensive fixed income approach

Up until October 2023, bond investors were resigned to accepting a third year of low fixed income returns and were hoping that 2024 would bring positive news. But when US data confirmed that inflation was falling quicker than expected, market sentiment rapidly shifted. The bellwether US 10-year bond yield fell sharply from a high of nearly five per cent to 3.8 per cent within two months time. The implication: the US Federal Reserve Bank would start cutting interest rates far earlier and far faster in 2024 than previously expected.

Before year-end it was clear that the bond market was already pricing in 150 basis points in rate cuts in the short term, or a move from 5.33 per cent to 3.83 per cent over 2024. "In a frothy few months," says LGT's Head of Fixed Income Strategy EMEA Simon Weiss, "we saw what we expected to happen in 12 months occur in just two!" 

This turnaround from bearish market psychology to a more bullish outlook was based on the idea that a hard landing - a recession - was unlikely, while a soft landing was far more probable. Traders had thought that the Fed would only cut interest rates in the face of a significant recession, but turned bullish as they became convinced by the soft-landing scenario combined with falling inflation figures that allowed for rate cuts. 

The long-short barbell

"While we were expecting, and still are expecting, rate cuts this year," Weiss continues, "we think that 75 to 100 basis points is more likely. It is very rare for the Fed to cut 25 basis points at every monthly meeting, which is what the current implied rate path of 150 basis points suggests." But as he explains, either scenario presents challenges for bond investors.

A barbell approach to fixed income investing can provide some opportunity and protection. This involves investing in longer-term government bonds and shorter-term corporate paper. The longer government bonds should benefit from a cooling economy and interest rate cuts. And as LGT expects credit spreads to widen this year, well-chosen, short-term investment grade corporate bonds may be an opportunity at current valuations.  

Several factors speak for a cautious approach. The bond yield curve is currently inverted, meaning that investors are better compensated for holding shorter-dated instruments than long bonds. Usually, investors receive a premium for lending money for longer periods. An inverted yield curve is an odd situation, but one that Weiss expects to reverse - in bond terms, normalise - in 2024.    

Resurrected correlations

A normalised yield curve would bring back more traditional buyers, such as banks and financial institutions, into the market for longer-term bonds because they would receive a more normal premium for their investment. 

It would also help re-establish a more traditional relationship between equities and fixed income, whereby bonds fall when stocks rise. In recent years, both asset classes have risen and fallen in tandem, depriving investors of normal sources of portfolio diversification. "In an environment with rising high yields and high inflation, bonds can't play the part of a hedge because holding longer-duration instruments doesn't pay," says Weiss. "If inflation comes down significantly, we should see the negative correlation between stocks and bonds reappear."

A normalised yield curve would also focus investors away from interest rate and duration risks, and back onto credit risk. This is why Weiss suggests that investors pick and choose the short end of their barbell strategy very carefully. That means focusing on stronger companies. "With credit spreads widening this year, though probably less than they would in a recession, investors are and will continue to be compensated for risk at the short end of investment grade credits, even if there is a stronger contraction," he says. 

The risk in pursuing a barbell strategy now include unexpected credit defaults as well as duration risk, or the risk linked to changes in interest rates. As the year unfolds, Weiss is eying each end of the barbell for potential changes. "One reason to keep an eye on the longer end is that we see very little upside from credit risk beyond short-term investment grade paper," explains Weiss. Any economic downturn, even mild, will see downgrades and defaults increasing, and doing so faster the further they are down the credit spectrum. "We have historically low default rates at the moment, but this could change," he continues.

Hard and fast rate cuts

A bigger opportunity may arise if the current economic scenario baked into bond prices doesn't occur. If the Fed does cut rates hard and fast, there is a risk that inflation will not continue to fall further but will in fact rise again. This could happen if labour markets remain tight and wage inflation re-emerges. If this were to occur, the Fed might be forced to backtrack and raise rates again. 

Another risk might simply be that the market's current scenario takes longer to unfold. "Instead of rate cuts in the first quarter, they might happen in the second quarter," says Weiss, "which is what we would expect." In this case the market would have run ahead of itself due to over-bullishness, and yields might readjust. This would surprise bond markets and could result in a rise in yields, which would be an opportunity for investors. 

In reiterating his advice about caution, Weiss reminds investors that although inflation has fallen substantially, it still has a way to go to reach central bank targets, and the impact of the significant rise in interest rates designed to help curb inflation will continue for some time. "We still think that rates will come down in 2024, but the question remains how far and how fast; so investors need to remain careful and be prepared to be flexible," he concludes.