Analyst Insight
Introduction
If you are one that pays particular attention to the financial markets, then you are likely hearing a lot of talk about bonds in recent months. This comes as most sophisticated participants in the global financial markets are seemingly changing their tune on their outlook for the asset class going into 2023. As an example, Credit Suisse, in their 2023 investment outlook, has expressed that they believe that fixed-income assets should become far more attractive to hold and offer greater diversification benefits. Likewise, JP Morgan has stated in their investment outlook that this might be the time for investors to increase exposure to bonds particularly further along the maturity spectrum.
In this piece therefore we will look at what has changed in the global markets that may have warranted the seemingly positive consensus view on bonds, and our views on bonds going into 2023. Lastly, we consider the key risks that one should look out for, and the possible options investors might have to gain exposure to domestic and global fixed Income.
The Market 2023
We can think of the yield we receive on bonds as payment for holding certain types of risks. While these risk premia are varied, such as credit risk, inflation, and currency risk, a simpler decomposition is a real interest rate component and an inflation risk premium. That is, for example, if the market is expecting inflation to be relatively elevated, then it will also require a higher yield to compensate for inflation eating away at its returns. Likewise, the real interest rate component contains a premium for the expected uncertainty of both economic growth and interest rates. That is, if the general risk-free interest rate in the economy increases, then investors would have already been locked into an instrument that has a lower relative interest rate and therefore investors will likely require a discount for the potential losses (i.e compensation for interest rate variability).
Given this conceptual framework, we can link this back to the recent developments that we have seen globally and domestically. Firstly, it is expected that some of the persistent drivers of global inflation in 2021 have been on a downward trajectory. This is inclusive of the alleviation of the numerous supply chain pressures, which have contributed to the persistent decline in goods inflation that we have seen from the last four US CPI readings. This has therefore led to the market consensus being, barring an extreme event, (for example, a drastic escalation of the Russian war in Ukraine) a significant fall in inflationary pressures throughout 2023 and hence by extension a decline in this required inflation premium discussed earlier.
This fall in inflation has also meant that the expectations that monetary authorities globally will reduce the pace of interest rate increases and also means that interest rate volatility is expected to decline in 2023. This is exemplified locally by the Bank of Jamaica’s recent announcement that they are temporarily pausing rate hikes. Additionally, signs of a slowdown in economic growth have effectively placed a firmer cap on how high market participants believe inflation may go. Both factors compress the real interest rate premium component of bond yields and when coupled with the compression in the inflation risk premia, are highly influential in the constructive sentiment on bond yields and therefore, bond prices (being that they move inversely).
Back to Diversification
While we are aligned with the expectation of global inflation declining in 2023, we are also still of the view that idiosyncratic factors are likely to leave inflation higher than historical norms (think pre- pandemic levels). However, the slowing growth and inflation, coupled with the impact of a fairly rapid monetary tightening cycle thus far, now necessitates a slower approach as the possibility for over- correction increases, underscoring our view that the headwinds associated with bond prices are likely to ease in 2023. Several structural factors had limited the ability of bonds to add meaningful value to a portfolio. This includes the generally low-interest rate environment pre-2022, which had reduced the total returns on bonds. Additionally, the elevated volatility in the macroeconomic environment has led to both bond and equity markets trending downward in tandem. The latter point highlights that equities and bonds have seen a positive correlation for the majority of 2022, which means that the diversification benefit of holding bonds was relatively negligible. Higher bond yields now, and the tempering of inflation (higher inflation regimes tend to coincide with positive bond asset correlations) means that the diversification benefit of the bond might just return in 2023.
Given the factors outlined above, individual investors could explore adding bonds to their portfolios in 2023. This decision to do so might contribute to some diversification benefit for your portfolio in 2023, without comprising too much in the way of returns given the higher interest rate environment. However, there still exists some risk factors to consider, such as, unexpectedly, higher and stickier inflation in the event of an escalation of geopolitical tensions and their impact on global commodity prices. For Investors who wish to add bond exposure to their portfolio, there exist several easily accessible options. These include Barita’s own FX bond portfolio unit trust that invests in global bonds and an Income fund that primarily invests in domestic fixed income. There also exist several other options which may be more appropriate for an individual investor’s particular needs. Against this backdrop, we advise potential investors to speak to an advisor about their options and its fit in their portfolio.
Written by Peter- George Simon
|
Full Newsletter & Report
