A re-assessment of fixed income securities and yields — and their defensive qualities — have made bonds attractive again. Here’s a quick overview from Pendal’s head of client solutions DALE PEREIRA

AFTER a decade of strong returns, bond markets have been challenging for investors over the past year.

Returns have not been kind.

But in recent few months a re-assessment of fixed income securities and yields — and their defensive qualities — have made bonds attractive again.

Bond returns don’t predict future returns – they reflect what has happened. That’s where the opportunity lies: they may be showing negative returns now, but the future looks a lot brighter.

Why bond yields are up

Markets are forward-looking – prices reflect where the economy is heading.

Bonds typically lead equities in terms of market reaction.

From the end of 2021 and into the first half of 2022, bond yields moved in line with expectations of future rate rises – which in turn reflected inflation expectations.

But markets often over-react when extrapolating good and bad news. And that’s the case now.

The market has likely priced in too many rate rises. It’s priced in a good chance that central banks around the world won’t be able to control inflation. (Though recently that pricing has started to dissipate, making yields less volatile.)

This means the bond market is at a much better entry point for investors.

But aren’t central banks already lifting interest rates?

They are, but remember bonds are priced on expectations.

We’ve seen a big jump in yields because investors initially expected things could get out of control with supply-chain problems and higher prices.

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There was plenty going on – Covid restrictions in China, the war in Ukraine, soaring oil prices and an energy crisis. It wasn’t long ago that people were talking about oil at $US200 a barrel.

Hence, central banks have acted aggressively.

In Australia we’ve seen consecutive 50-point rate hikes – the fastest rate-rise path in our history.

Other countries such as the US, UK, Canada and New Zealand have been even more aggressive.

Central banks understood their objective and acted to curtail inflation expectations. If they hadn’t, inflation expectations could quite easily have become reality.

What’s the prognosis for inflation?

In recent weeks there are early signs that inflationary pressures may be dissipating.

The flipside to reduced economic activity and price pressures is the prospect of a recession.

That’s an environment when bonds outperform.

Why bonds could be a good investment now

If inflation has peaked — and we’re now only expecting moderate inflation – that’s a good environment for bonds, since the starting point is a higher yield.

Coupon payments (and income) is higher. Plus there’s limited downside risk in terms of capital loss.

If we head into a recession, there’s a call option on bonds. That means the issuer can redeem the bond before its maturity date.

So the asset from which you are getting a coupon is at least in line with long-term inflation.

And it will appreciate in value if we do head into a recession.

What about corporate bonds?

Until recently, many corporate bond investment strategies were hit with a double whammy of interest rate risk and credit risk.

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Corporate bonds are more susceptible to an economic growth slow-down and potential recession. Investors may worry that companies won’t be able to repay their debt.

The market has anticipated this and re-priced corporate bonds.

The riskiest companies don’t have a strong balance sheet. They may be operating in an environment where margins are under pressure because costs are going up while sales are flat or falling.

But that’s the worst-case scenario.

In Australia there are many investment-grade corporates with strong balance sheets.

How to invest in the bond market now?

Investors should consider a “barbell” approach.

At one end of the barbell, consider buy high-quality government bonds for duration.

Australia looks like a good place to re-enter the market. If investors already hold government bonds, now is not the time to sell because that would lock in losses.

Look for actively managed portfolios, because opportunities depend on choosing the right maturities of a government bond.

For example 5-and-10-year bonds — which take into consideration medium-term impacts of inflation and growth — now present interesting opportunities that active managers can exploit.

At the other end of the barbell, investors should consider investment-grade bonds which represent quality companies with good cash flows.

In Australia the level of default in investment grade bonds is much lower than the US, because of our higher-quality balance sheets.

Investors can also look for floating rate investments issued by corporates.

This means investors are less impacted by rate rises. They get an increase in income every quarter as the cash rate rises.

Floating rates haven’t been a good investment in recent years as interest rates tended down.

But in this environment they can outperform term deposits since investors pick up extra accrual as rates rise.

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Other opportunities can be found in the fast-growing impact or “use-of-proceeds” bonds, often known as green, social or sustainable bonds.

Strong tailwinds in climate, regulation and human behaviour change mean there is increasing demand for these types of bonds — and not enough issuance.

This dynamic is likely to continue.

Dedicated strategies can find strong returns along while aligning with client principles.

ESG (environment, social and governance) has a different meaning in bonds compared to equities. Capital can be ring-fenced for specific projects or uses and the main elements of credit risk and duration risk can be managed.