With the risk of a global recession still hanging over equity markets, bonds are a way for investors to supplement their income while retaining the potential for capital appreciation
There are few years that were as bad for bonds as 2022. In fact, the returns on 10-year US Treasuries in 2022 were at –19.5%, the worst performance in a century.
The reasons for this are widely known: US Fed rate hikes and persistent inflation sparked by Covid and Ukraine war-induced commodity price rises, but more recently, by labour shortages especially in the services sector. This perfect storm of negative forces hit all bond sectors, from high-grade to high-yield, and from short- to long-duration.
A winner in all scenarios
However, bond total returns – a combination of yields and capital appreciation – look set to rebound in 2023 for several reasons:
1. Yields are at their highest levels in over a decade. If, as we expect, the Fed funds rate pauses and holds at 5% in 2023, and the global economy manages a soft landing, then bond yields alone should be attractive enough to drive demand.
2. However, if a deeper slowdown occurs and bond yields continue to rise, then this high level of yield should provide a buffer against possible price declines.
3. On the other hand, if the Fed’s actions succeed in bringing inflation under control and the Fed pivots towards rate cuts, we would expect bonds to show capital gains. Corporate bonds are key potential beneficiaries given companies’ good fundamentals.
We believe bonds as an asset class are evolving from a perfect storm scenario to a win-win
Positive outlook on most sectors
Our base case – that we are near the end of the rate-hiking cycle and most of bond losses are behind us – is a positive backdrop across most bond sectors.
Developed market (DM) government bonds
We are positive on this bond sector as DM central banks look likely to pause their current rate-hiking cycle. Despite the inverted yield curve (that is, short-duration bond yields are higher than longer-duration bond yields), we think investors should consider a barbell approach. This approach is based on a portfolio of both short- and long-duration bonds. In the event of a downdrift in US Treasury yields, this approach would allow investors to lock in higher yields over the longer term. Additionally, a potential pause in the rate-hiking cycle should see the long end of the yield curve stabilise further.
Investment-grade (IG) corporate bonds Looking ahead into 2023, we prefer IG corporate bonds, that is, those rated BBB– or higher, over high-yield corporates. The balance sheets for many high-quality companies look strong after these firms borrowed at low fixed interest rates during the pandemic. While lower-quality corporate bonds are offering highly attractive yields, they also carry higher default risk that may come to the fore should the global economy tip into a recession. Given current IG bond yields of around 5.0% and expected moderation in inflation rates, investors stand to earn real income (that is, income in excess of inflation) without the need to take on higher risk.
Emerging market (EM) bonds 2022 was a difficult year for EM bonds. In our view, EM bonds were oversold last year and yields are actually very attractive. Additionally, China’s reopening could help to boost the growth outlook for emerging markets, especially within Asia. As such, we have a positive stance on Asian and Singapore bonds. With the IMF projecting China’s economy to grow 5.2% this year, the region offers good fundamentals and value, especially given the underperformance from China previously.
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A win-win situation
We believe bonds as an asset class are evolving from a perfect storm scenario to a win-win. High income demand, moderating inflation and peaking interest rates are creating a conducive environment for bonds. With the risk of a global recession still hanging over equity markets, bonds are a way for investors to supplement their income while retaining the potential for capital appreciation. This is important for individuals looking not just to increase their spending power, but also to build their long-term wealth.
Chong Jiun Yeh is chief investment officer at UOB Asset Management
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