This article was contributed to us by Fidelity International and has been edited lightly. You can read the original article here.
What DollarsAndSense Thinks: The current high interest rate environment and expectations of eventual rate cuts present an opportune moment for bond investments. However, investors must understand the market and stay informed on how to capitalise on fixed income opportunities as the market evolves.
As inflation eases globally, attention has turned to market expectations of rate cuts by major central banks and what these could mean for fixed income investors.
From an initial expectation of six or seven US Federal Reserve rate cuts in 2024, the market is now pricing in four as economic headwinds and tight monetary policy continue to feed into the real economy. Against this ever-evolving market backdrop, where do bond investors look for opportunities?
The hunt for yield has not cooled. Despite tight spreads in the Investment Grade market, global investors are flooding into US Investment Grade bonds to position themselves to “catch the turn” when rate cuts arrive.
Global and US aggregate strategies have benefited most from this demand due to their attractive income prospects and potential for capital appreciation. With potential interest rate cuts on the horizon underpinned by further slowdown in the economy and inflation in the US, investors might want to consider longer-dated bonds offering significant capital growth potential with each 25 basis-point cut.
Attractive Yields In Government And Corporate Bond Markets
Government bond yields are currently offering better value as compared to higher-risk assets. The income level available from quality securities such as 10-year US Treasuries, for example, is at historically elevated levels relative to dividend-yield returns from the S&P500.
Investors can earn upwards of five per cent on investment grade corporate bonds, which is an attractive base for any diversified portfolio, and provides a good cushion against the current volatility in interest-rate-sensitive markets.
The world will eventually move into a rate-cutting environment, which historically has been positive for fixed income capital appreciation.
Also, in the US Investment Grade segment, the long end of the curve has witnessed robust buying activity, which means credit spreads are close to the tightest we’ve seen. Still, opportunities exist at the front end, and the resulting inverted curve means attractive all-in yields.
Downside Risks Are Priced-In
Fundamentals remain relatively healthy, with corporate leverage in the Investment Grade and High Yield markets at historic lows.
Economic headwinds in the US, though, include increased pressure on consumers and medium-term labour market risks, which means there is little margin for error in higher-risk assets. On the other hand, investment grade bonds, especially US Treasuries, are now starting to price in a further slowdown in the economy with close to 100 basis points of cuts to the US base rate priced before January 2025.
Any further deterioration in growth or labour market data could trigger a rapid acceleration in the cutting cycle and catalyse a spell of US bond outperformance.
In this environment, an agile approach and credit selection will remain vital.
Financials Poised To Outperform?
While expensive valuations in emerging-market and High Yield debt warrant defensive positions, and the US Investment Grade market remains tight, we still see pockets of opportunity in corporate bonds. Given their robust fundamentals, we like the financial sector, especially European “national champion” banks and large US lenders.
Asia Adopts A ‘Wait-And-See’ Approach
In Asia, most central banks are cautious about rate cuts despite high positive real yields. They await clearer signals of easing from the US before making significant policy adjustments. On the other hand, ongoing reflation in Japan has enabled the Bank of Japan to end its policy of negative interest rates and yield curve control at the end July with the potential for more hikes over the medium term.
In a global context, Asian US-dollar High Yield bonds present compelling opportunities as they benefit from attractive valuations, moderate duration, and stable fundamentals.
High-grade onshore bonds in China also present attractive risk-adjusted returns, aided by a dynamic economic backdrop, monetary easing, and subdued inflation. Medium duration high-quality China onshore bonds, on a US-dollar-hedged basis, have the potential to deliver robust, total returns over the next 12 months. Their low correlation with global assets also makes them an appealing diversification tool.
If you’re interested to learn how to generate income through fixed income investments or other income solutions like equity income and multi-asset income, you can find out more at Fidelity. You can also download Fidelity’s 2024 Income Guide for more insights.
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