Slower growth expected to weigh on shares in 2023. Will bonds do better?

Experts

With improved valuations, is the worst behind for bonds, asks Bruce Murphy, Director of Australia and New Zealand at Insight Investment.
Photo by Michael M. Santiago/Getty Images

Fixed income valuations have improved dramatically after last year’s sell-off and after a decade of quantitative easing. The consecutive rounds of rate rises have boosted the relative appeal of bonds. Inflation is finally starting to moderate in the US, and the risks of recession are rising. Eventually, instead of fighting inflation, central banks may need to lower interest rates. This would likely force bond yields lower and prices higher, and that could generate some very attractive fixed income returns for investors.

At the same time, an expected slowdown in economic growth is likely to keep share markets down this year; government bonds and corporate credit may well perform much better than they did in 2022 – as inflation and economic growth moderate and higher interest rates stem business activity.

According to OECD estimates, the Australian economy and other developed nations are expected to slow quite markedly in 2023 as the lagged impact of interest rate rises impact home borrowers, with consumer spending slowing in response to those higher mortgage rates.

In fact, the OECD expects the Australian economy to grow by just 1.9% in 2023, a relatively sharp slowdown from 2022.

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Elsewhere, annual GDP growth is projected to slow to just 0.5% in the US in 2023, and 0.25% in the euro area, with substantial economic uncertainty leading to significant downside risks. Growth in China has also slowed and is expected to drop to 3.2% in 2022. Except for the 2020 pandemic period, this will be the lowest growth rate in China since the 1970s, again according to the OECD.

As economic growth slows, and the tightness in the labour market subsides, inflationary pressures are expected to diminish. These factors combine to support the value of bonds, which are arguably offering more attractive yields than in years past.

With improved valuations, is the worst behind for bonds?

The improved valuation of bonds will come as a big relief to bond investors. The 2022 year recorded the worst 12-month period on record for bonds. That was largely due to the US Federal Reserve raising interest rates aggressively, which slashed bond prices, especially for long-term bonds.

A 60:40 portfolio posted the worst losses in nominal terms since the global financial crisis of 2008-09. That led some investors to reconsider the traditional way portfolios are constructed with 60 per cent allocated to shares and 40 per cent to bonds.

So, given the recent negativity, the question for investors is to ask whether the worst of the price losses are behind us, and can fixed income act as a valuable portfolio diversifier in 2023?

The answer from my personal perspective is a qualified yes.

Given this macro-outlook of slowing economic growth, I expect to see investors increase their allocation to government and corporate bonds this year. The role of bonds as both a portfolio diversifier and return enhancer is certainly looking more likely given the relative rewards available to investors from government, investment grade, and high yield bonds.

Catching fallen angels

One sector of the fixed income market that is particularly appealing is ‘fallen angels’ – bonds which have been downgraded from investment-grade or BBB status and now sit at the top of the high yield market with a BB credit rating. These bonds are typically oversold at the time of downgrade, creating an excellent purchasing opportunity and with many recovering markedly in the short to medium term, delivering strong returns. Some fallen angels also achieve a return to investment grade, and with that, further price appreciation, so they are considered rising stars. In other words, if the debt of companies is re-rated back to investment grade status, investors stand to make further profit.

With the current cash rate in Australia at 3.35% and investment grade bonds yielding around 5.6%, investors are reaping a credit spread or reward over the risk-free cash rate of about 1.25%. Moving down one notch to BB debt and the fallen angels segment, those bonds are yielding around 3.5% over the cash rate. This is a relatively attractive investment proposition and good compensation for risk relative to, for example the average one-year term deposit rate paid by Australian banks in January 2023 of 2.9%, and just 3.2% p.a. on two-year term deposits. You got even less on six-month term deposits, just 1.9% p.a..

For investors seeking attractive income from a liquid, well diversified portfolio that aims to participate in the gains available at and following a credit downgrade, the Insight Investment High Income Fund, which focuses on the US Fallen Angels bond index, hedged to remove USD currency risk for Australian dollar investors, offers such exposure.

With increased dispersion and volatility in global share markets, demand for equities has been replaced by greater demand for fixed income in 2023. Insight Investment believes that genuine innovation such as the Insight Investment High Income Fund aims to deliver to investors a unique approach to extracting profits from the bond market at acceptable levels of risk.


Bruce Murphy is Director of Australia and New Zealand at Insight Investment


This article should not be regarded as the provision of advice of any nature from Forbes Australia.  The article is intended to provide general information only and does not take into account your individual objectives, financial situation or needs. Past performance is not necessarily indicative of future performance. You should seek independent financial and tax advice before making any decision based on this information, the views or information expressed in this article.

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