Currently, the markets seem to be in upheaval: rapidly changing interest rates, high inflation, geopolitical upheavals and fears of recession. How should one invest in such a situation? Amanda Stitt, portfolio specialist at T. Rowe Price, presents five possible bond strategies to Fondsfrauen.
Uncertainty remains high as investors grapple with a range of issues. These dynamics are challenging for portfolios, but the good news is that bond yields are at their most attractive levels in more than a decade. This means that not only do women investors have the opportunity to earn higher returns from bonds, but they also have a margin of safety to protect them if interest rates rise again. After a difficult period, bond markets are now much more attuned to the new market realities.
Opportunities in high-grade government bonds
The stock of debt instruments with negative yields has all but disappeared thanks to the significant repricing of bond yields over the past year. This has led to improved valuations in high quality government bond markets, where yields are among the highest since the global financial crisis. In some cases, such as the US Treasury market, the yield curve is inverted - a scenario in which short-term yields are higher than those on longer-dated bonds. With economic growth expected to slow further, the duration of high-quality bonds should become increasingly attractive as the year progresses. Inflation is also showing signs of cooling and is expected to weaken further, raising the possibility of positive real yield curves on government bonds in the future. This is a potentially tempting opportunity, but selectivity is key as some countries will need to issue large amounts of debt to finance their fiscal deficits this year at a time when central banks are either reducing their purchases or actively selling.
Absolute return bond strategies can help with portfolio diversification
Absolute return bond funds can respond tactically to changing market conditions, making them an attractive choice in a range of different environments, including volatile times. These non-traditional fixed income strategies are typically benchmark agnostic and can mean a broader approach, with the ability to invest in a variety of regions, sectors and security types. However, investors should be aware that strategies within this category can differ significantly.
Thus, those seeking potential portfolio diversification should look for an absolute bond fund manager that has a low or negative correlation with major market indices, such as the S&P 500. Coupled with the ability to react tactically to changing market dynamics, strategies with these correlation characteristics offer investors the potential to generate returns in a variety of different market environments.
High-yield bonds offer attractive long-term income opportunities
Many investors are looking to the fixed income market for a steady stream of income. And although there are headwinds in the face of slowing growth, extreme volatility and the sharp rise in government bond yields have pushed corporate bond yields up significantly. Indeed, they are now at levels that offer potentially attractive return opportunities to investors with a longer time horizon.
Some credit sectors, such as global high yield bonds, are offering yields in excess of 9.1% - levels not seen since the global financial crisis! Importantly, even if the economy worsens, companies could be in a better position than in previous downturns, as corporate balance sheets have strengthened since 2020. Moreover, the current downturn differs from previous downturns in a number of ways. Namely, it is the result of inflation and the sheer number and speed of interest rate hikes to contain it. In contrast, the market declines that accompanied the tech bubble and the global financial crisis were due to investor concerns about the creditworthiness of certain assets, including overvalued tech stocks and excesses in the US housing market. However, investing in credit markets involves greater risk than in government bond markets, and the further down the credit scale the investor is, the higher the risk. Although corporate bonds can offer tempting opportunities, it is important to conduct a thorough fundamental analysis. This helps to identify the best opportunities and manage the risks prudently.
Impact bonds offer the opportunity to invest in companies that want to make a positive impact
The environmental and social pressures facing the world have never been greater, but so has the opportunity to invest in companies that are leading the way in addressing these challenges. So-called "impact investing" is not a new asset class: it is a natural extension of environmental, social and governance (ESG) investing, made with the explicit intention of generating a positive environmental or social impact AND a financial return. These companies tend to be more adaptable to changing demand patterns, laws and regulations and should be in a good position to offer potentially attractive investment opportunities. However, some aspects of the market, particularly debt securities with an ESG label, have proven vulnerable to greenwashing - that is, where some securities give a false impression or provide misleading information about an organisation's environmental credentials. This highlights the importance of fundamental research to minimise this and identify potentially positive companies. It is also important to choose an asset manager that looks beyond the market for the labelled bonds, as impact can also be identified, captured and measured by deliberately directing capital into issuers that seek to have a positive impact on the environment or society through their end activities.
Emerging markets offer earnings potential and diversification benefits
Emerging market bonds also represent a potential opportunity for an offensive strategy for investors with an appropriate time horizon. Similar to corporate bonds, emerging market bond yields have reached levels that offer investors potentially attractive income opportunities. They also offer broad opportunities to diversify interest rate risk. While the US Federal Reserve and other major central banks are tightening monetary policy, not all countries are at the same point in their monetary policy cycle. In fact, several emerging markets have started raising interest rates earlier, so they are further along. Brazil and Hungary, for example, seem to have peaked and completed their rate hikes. This could be a good entry point for investors, especially if a significant economic slowdown leads countries to lower interest rates. Again, it is important to note that emerging markets are exposed to higher credit risk than developed markets. Therefore, bottom-up research is essential here.
This not only helps to gain exposure to countries with different interest rate profiles, but also to identify opportunities when prices have moved away from fundamentals.
The photo shows Amanda Stitt, Portfolio Specialist at T. Rowe Price.
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