Posted inFixed Income

Duration to drive bond returns

As recovery in the bond markets persists in the face of growth and inflation, rotating from credit to duration will provide returns during the coming quarters, says PGIM Fixed Income.
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Although inflation might be higher than anticipated over the medium-term, PGIM believes the global recovery is likely to deepen and expand during the second half of the year.

This follows a quarter (April to June 2021) that saw the bond market rebound, seemingly in the face of fundamentals.

“Our supposition of a resumption of the bond bull market appears to be underway with a rotation from credit to duration, but with the caveat that the outlook remains uncharted,” said Robert Tipp, chief investment strategist and head of global bonds at PGIM Fixed Income.

Bond buyers eyeing duration

The fund house expects that the market has hit the top in rates, mostly due to investors curbing their long-term expectations for growth and inflation.

“Both may remain elevated over the next few quarters, but over the long haul, secular fundamentals seem destined to bring back moderate growth and below target inflation,” Tipp explained.

Yet there is also still a possibility of a twin peak later. Either way, he said forward rates continue to appear too high, suggesting duration is likely to contribute to bond market returns over the quarters ahead.

At the same time, supportive credit trends and a search for yield look set to fuel further credit sector outperformance, while volatility will likely present opportunities to add risk, Tipp added.

While ever-tighter credit spreads limit potential upside going forward, the central PGIM scenario is that spread products will generally continue to outperform. “Fundamentals remain supportive and the overall environment of low interest rates will keep investors moving out the risk spectrum in search of higher yields,” said Tipp.

Inflation warning signals

Bond investors will, however, need to contend with the growing risk of higher-than-expected inflation.

“We had anticipated an episode of higher inflation, but we did not expect to see the effects quite so soon or to be so vigorous,” said Nathan Sheets, chief economist and head of global macroeconomic research at PGIM Fixed Income.

As a result, the firm is sensitive to the risk that markets might continue to be surprised by inflation. “It may take longer for inflation to come back down or, in any event, medium-term inflation may be somewhat higher than we anticipate.”

Such concerns have been fuelled by roaring US CPI readings in recent months and reinforced by producer price increases around the world. For example, global core goods inflation has been well above 3% in recent months, compared with 1% to 1.5% before the pandemic.

Central banks will therefore need to guide domestic economies through these competing dynamics.

To date, central banks in developed markets (DM) have felt comfortable looking through the conflicting signals and have kept rates on hold, said Sheets. “However, we expect DM monetary policy to remain highly stimulative through at least this year and much of next year.”

The challenges for emerging markets (EM) central banks are perhaps even more acute; six of them have increased rates in recent months, with several others likely to follow this in the coming year.

“Thus, an increasing divergence between DM and EM central banks, as countries battle through the inflation upsurge, is likely to be a key feature of the global outlook moving forwards,” added Sheets.

Part of the Mark Allen Group.