Fixed income investors should look at the significant year-to-date market falls as offering long-term opportunities rather than a sign of more doom and gloom to come.
While many bond investors who avoided being overly exposed to duration have been rewarded on a relative basis during the sell-off so far this year, M&G Investments thinks that now might be the time to start reversing some of these positions.
“Base effects could mean that we see well-publicised annual inflation figures come down over the course of 2023, which should be positive news for bond markets, particularly as a US-led hiking cycle now appears to us close to becoming fully priced in,” said the UK fund house.
For example, the 10-year forward rate in the US Treasury bond market – the average expected US Federal Reserve (Fed) Funds rate in 10 years’ time – is currently 4%; historically this has been a strong buy signal for US Treasuries.
Other key parts of the fixed income universe that M&G Investments suggests investors consider include emerging market (EM) debt and developed market investment grade credit.
Inflation effects set in
Elevated inflation levels have the potential to make investors feel like they are suffering from a shrinking list of areas to park their cash.
Indeed, most risky asset classes posted sharp falls in the days following the release of the bleak US inflation report that showed price rises accelerating – with the headline annual rate at 8.6%, up from 8.3% in April and above most forecasts.
This followed several weeks of falling government bond yields, and even a brief recovery in global equity markets, as investors began to factor in the potential for a softer central bank tone going forward, said M&G Investments.
Selective bond buying
The firm sees the EM debt space as historically attractive following significant drawdowns this year based on heavy investment outflows and now elevated yields.
“Despite the ongoing strength of the US dollar and global economic headwinds, we think there are now some very attractively priced areas of the market on offer,” said M&G Investments.
Performance in regions such as Latin America, for instance, has remained relatively well-insulated from the effects of the war in Ukraine, the firm added. Many countries on the continent continue to benefit from elevated commodity prices.
In addition, the UK manager believes developed market investment grade credit has been underappreciated lately.
While market liquidity remains challenging in some areas, the firm feels there are now opportunities to selectively add new positions from here.
“Braving corporate bond exposure hasn’t been easy given some of the anemic returns we’ve experienced over the last few years, but we are seeing signs of increased interest in this area of the market, with clients clamouring for products offering higher yields on their investments,” said M&G Investments.
More specifically, the yield on global investment grade credit has doubled during 2022.
At the same time, investors shouldn’t discount a scenario where bonds get significantly cheaper, added the firm. This might happen if the inflation picture continues to deteriorate.
“While we expect inflation to cool soon, it seems likely to remain elevated well above many of the major central banks’ inflation targets for some time yet. A policy-induced hit to global growth could also cause corporate default rates to rise.”
