Bonds – if not now, then when?

Much of the bond market is more attractively priced now than it has been for much of the past decadeInvestors thinking about making an allocation should be asking themselves: if not now, then when? Written by Olivia Buah, senior consultant at LCP.

2022 has seen a historic slump for bond markets, with the Bloomberg Global Aggregate Total Return Index down over 20% since its peak in 2021 (on an unhedged basis) – the greatest fall since its inception in 1990.

This comes as a result of rampant inflation, central banks increasing interest rates and credit spreads continuing to rise. The combination of these has led to large falls in the value for the majority of fixed income markets, including bonds. With equity markets also falling, bonds in general didn’t offer the protection they once did.

Furthermore, the impact of dwindling consumer confidence as well as looming recessions around the world are both harmful to companies and their ability to meet their debt obligations, which doesn’t bode well for bond markets. In addition, further increases in interest rates would have a negative impact on the prices of fixed rate bonds, with a larger impact for bonds with higher ‘duration’ – a measure of a bond’s sensitivity to movements in interest rates.

So why invest in bonds?
This slump has provided would-be investors with an opportunity to invest in this diverse asset class at cheaper prices and a higher yield. Around three quarters of the global corporate bond market now yields over 4% pa to investors, compared to only a very small fraction of the market a year ago.

Beyond this, while no investment is guaranteed to succeed, the diverse opportunities within the bond market can provide investors with a flexible range of assets which can generate returns, act as hedging instruments or be a source of regular income.

Putting a portfolio jigsaw together
High-quality investment grade issuers currently have healthy balance sheets and solid fundamentals, meaning they should be well set to manage the ongoing economic headwinds we are facing and repay investors. When it comes to investment grade, we prefer a buy and maintain approach, holding high-quality bonds until their maturity. This can offer a good balance between active and passive management styles, which keeps transaction costs and management fees low.

Meanwhile, in the sub-investment grade space, yields have risen by more than investment grade bonds and it is significantly more attractive to enter the market now than at the start of the year. However, indications of a ‘Covid hangover’, through interest coverage ratios falling and default rates increasing, mean investors should proceed with caution. It could be argued the best way to access sub-investment grade markets is via a multi-asset credit strategy.

The flow of capital from institutional investors into illiquid credit assets is one of the biggest investment trends of the last decade, with direct lending the most straightforward type. Historically, as traditional banks stepped back from lending to small-to-medium sized companies, institutional investors stepped in to fill the gap in the market, leading to sizeable returns for medium term investments. Unfortunately, given the rise in yields for other credit assets, investors are no longer being compensated for illiquidity to the same degree within the direct lending space. However, the good news is that the illiquid credit universe is so much more diverse than just direct lending, with other asset classes including stressed and distressed debt, infrastructure debt and real estate debt.

“Having a diversified bond portfolio to manage the challenging economic environment is pivotal.”

With bonds being utilised by investors in a number of different ways, having a diversified bond portfolio to manage the challenging economic environment is pivotal – as some parts of the market will deliver returns when others are not. This could mean constructing a portfolio of investment grade bonds; while those who can afford to lock up their money for longer could look to illiquid credit.

This flexibility will be vital for investors looking to take advantage of the attractive pricing and higher yields on offer – as many credit assets look resilient and others could even thrive. So, when it comes to the question of investing in the bond market: if not now, then when?

© 2022 funds europe



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