Has the fixed income ship already sailed?

As the halfway mark of the year approaches, our Fixed Income Investment Team evaluates whether such proclamations are correct.

In order to find out whether investors have missed the boat or not, we look at two main factors: fund flows and attractiveness of the entry point.

Fund flows in the first quarter of 2023 suggest we are yet to reverse the aggregate negative net flows into active bond funds that took place in 2022. While the picture varies from one category of active bond funds to another, the total net inflow of $43 billion in Q1 2023 was a fraction of the average quarterly net outflow in 2022 of $163 billion (Figure 1).

Moreover, some categories (high yield, emerging markets) experienced continued net outflows in Q1 2023.

Investors have been cautious due to concerns about a softer growth outlook, potential impact of banking-sector issues on the wider credit market, as well as persistent inflation. This has kept many on the short-end of the curve and in money market funds, which are relatively low risk and attractive due to the inversion of the yield curve.

However, might now be the right time to re-evaluate that approach?

One way to evaluate attractiveness of fixed income is to look at the so-called ‘yield break-evens’, which we define as how far bond yields would have to rise to offset the income earned on the bond in a year. In effect, how much does the income earned in a year protect against mark-to-market price losses if yields rise. Therefore, the higher the break-even level, the greater the buffer a bond has against any given volatility in rates.

Looking at the selection of fixed-income asset classes shown in Figure 2, break-evens have changed much between December 2021 and May 2023. In other words, entry points for the asset classes in question have become more compelling.

Incidentally, the resilience of bonds has also been demonstrated by performance so far this year. Specifically, both the investment grade (IG) and high yield (HY) bonds posted significant and positive returns in the first five months of 2023 despite all the headwinds (hawkish major central banks, recent banking sector turmoil, continued geopolitical uncertainties). Moreover, both the IG and HY segments outperformed money markets and short-duration bonds by about 1% in the year-to-date as of 31 May 2023 (Figure 3).

Looking ahead, the increase in yields that has taken place since the end of 2021 has created a significant positive directional asymmetry in returns for a given magnitude of a hypothetical move in interest rates.

Specifically, looking back to December 2021, a 50 basis points (bps) increase in rates would have resulted in a 12-monh -2.6% return for a 10-year US Treasury (UST) security. The same move in rates would have resulted in much less pronounced negative returns for a 10-year UST bond in the 12 months from May 2023 (Figure 4). This improvement in resilience to rate shocks is by and large due to the increase in the yield of the 10-year UST bond by 210bps over the period.

Finally, the major central banks appear to be close to the peaks of their tightening cycles, with the policy rates expected to fall in 2024 and 2025. For instance, the Federal Reserve’s projection, released earlier in this month, predicts that the target for the federal funds rate would fall by about 170bps from the current range by the end of 2025 (based on the median projection).

On the one hand, we cannot rule out that inflation might remain stickier than expected, which would imply the elevated policy rates persist for longer than is currently priced in. However, in our view this is mitigated by the (already mentioned) significant yield buffers available.

On the other hand, waiting until positive momentum has already made headlines could prove too little too late given where yields are at present. Indeed, investor mood might already be turning more favourable towards fixed income.

By way of example, the UBS Global Family Office Report 2023 (link) indicates that family offices may be planning one of the largest shifts in asset allocations in years, with fixed income being the most popular source of diversification. In particular, after three years of reducing exposure to bonds, almost four in ten (38%) are planning to add over the next five years. In other words, while the ship is still open for boarding, waiting until after the last call has been made could leave a would-be traveller stranded.