Volatility in the bond market is worth tolerating for the potential yields, says Stuart Chilvers, Rathbone Ethical Bond Fund manager.
Writing a review of the year in early November is a risky game. Writing a review of the year for bond markets in November 2023 is more so, given the volatility we have seen this year. It’s gotten particularly wild just in the past couple of weeks. So I will steer clear (to a degree!) from that, but it’s certainly worth thinking about what we bond investors can learn from 2023 and take into the years ahead.
Investors came into 2023 with a somewhat nervous attitude towards bonds. And understandably so. Traditionally regarded as the lower-risk assets in portfolios, in 2022 bonds had delivered the worst calendar year return in a generation, no doubt leaving some investors with mental scars. What’s more, the driving force behind these losses – rapidly rising interest rates sparked by rampant inflation – showed no sign of respite as 2023 dawned.
However, as we had argued at the start of the year, the starting point for bonds in 2023 was very different to that of 2022. For one, yields were much higher in 2023, meaning that they could rise much more significantly and bonds would still produce a positive return compared to 2022. That’s a result of much greater ‘carry’ or cash returns on the bonds, as well the fact that a given change in yield has a greater effect when yields are smaller. Secondly, investors expected that interest rates would continue to rise in 2023, so that was already incorporated into prices. Albeit, the rise in interest rates was actually a bit higher than most expected.
Carried home by higher yields
So where does this leave us year-to-date? If you had invested in the gilt index, you would have lost just under 3% at the time of writing. Not great, but far from the losses of 2022, given this year’s rise in interest rates and government bond yields. If you had decided to take some credit risk and invest in sterling investment grade credit, returns would be slightly positive – because of the additional yield generated from credit spread, the tightening we have seen in those credit spreads and the lower duration of this index. High yield returns have been better, as they are even lower duration and have higher credit spreads because of the higher level of credit risk they pose.
Focusing on investment grade credit – the path to these returns hasn’t been smooth. Volatility throughout the year in government bonds (which feed through to investment grade bond prices) was driven by many investor concerns, from where interest rates will eventually peak to fiscal profligacy. While credit spreads have tightened in 2023, it wasn’t a straightforward path – particularly in March as the solvency of several US regional banks threatened becoming a systemic issue. Perhaps the biggest surprise of the year has been just how resilient consumers and companies have proved in the face of higher rates.
So, what can we take from this going forward? We think that interest rates have now likely peaked (which historically has been an attractive time to buy long-dated bonds), but we think volatility within government bond markets isn’t going anywhere. We think it will be greater than we all got used to for much of the past decade. However, with yields now much higher, you’re getting paid for that risk.
We are less optimistic than the market about the likelihood of a ‘soft landing’. While the economy has proved tougher than expected so far, we think the ‘long and variable lags’ associated with monetary policy are yet to fully play out. That leaves us more circumspect on high yield bonds, given their weaker credit profiles, and while an economic downturn could drive investment grade spreads wider as well, we feel we are being compensated for this risk given the current yields on offer. Added to this, the real risk is the loss of capital that happens when you don’t get repaid and historically defaults are rare within investment grade credit. If we are right and a recession arrives in coming quarters, investment grade credit could benefit from interest rate cuts (depending on inflation levels) because of its longer duration compared with high yield bonds.
But even if we are wrong and the economy continues to forge ahead, this year has shown that investment grade bonds can still offer attractive returns. If the economy remains strong, we would expect credit spreads to tighten or stay flat – while government bond yields might rise as the timing of rate cuts is priced out. This year has shown that this doesn’t necessarily mean negative returns. So while we might have to endure higher volatility than we’ve become accustomed to within investment grade credit, we think that’s worth tolerating for yields at levels rarely seen in the past decade and the potential for positive returns in a number of scenarios.
Any views and opinions are those of the investment manager, and coverage of any assets held must be taken in context of the constitution of the funds and in no way reflect an investment recommendation. Past performance should not be seen as an indication of future performance. The value of investments may go down as well as up and you may not get back your original investment.
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