Last year, the theme across fixed income was that bonds are back. Fixed income finally offered significant and positive yields, which was a stark contrast to the negative-yielding environment which European investors had become accustomed to. As we look forward to 2024, the same thematic remains relevant, bonds offer positive yields and are an attractive consideration in any portfolio. What will matter most in 2024 however is the type of bonds which investors consider.
Over the last two years, central banks globally have embarked upon an incredible tightening path, hiking interest rates at a record pace to record levels to tackle record inflation figures. This significant move up in interest rates had a knock-on impact on bonds, whose price performance is inversely related to interest rate moves, leading to losses across the board for bond markets.
Of course, the moves were not all equal with longer duration bonds, which are more sensitive to interest rate moves relative to shorter duration bonds, suffering larger declines. From an investment perspective, this backdrop meant that investing in short duration, low interest rate-sensitive investments has been the best strategy for investors looking for yield without unfavourable price performance.
A shift in the return outlook
As we look forward to 2024, expectations are for central banks to start cutting interest rates by the second half of the year, marking a shift in the return outlook for bond markets. Whereas the last few years have been about defensive yield opportunities, we think that 2024 onwards will mark a turning point for bond returns and the type of investments that one can consider.
So, what type of investments should one consider? The answer is based in our expected returns outlook. For simplicity, the decisions within fixed income can be framed as a choice between two factors: should one consider long or short duration bonds, and how should they allocate between corporate and government bonds? Based on our expected returns outlook, we view longer duration assets as more attractive relative to shorter duration assets, whilst high quality investment grade corporate bonds also remain attractive.
Longer duration in favour
Focusing on the choice between short duration and long duration bonds, our view is that inflation is falling successfully, and so the path for interest rates will be to move lower over time. Against this backdrop, the expected returns for longer duration assets are most favourable as these assets will experience higher positive returns following a fall in interest rates.
Of course, interest rates will not fall in a vertical line, and so, it is important to increase any exposures in a gradual and risk managed manner over the short term.
Allocating between corporate and government bonds
When it comes to the second aspect, the deciding factor when choosing between corporate and government bonds will always be the growth outlook. Corporate bonds, issued by companies, are considered riskier than government bonds and as such will offer a higher yield to compensate investors for the additional risk.
Our view that economic growth will be low but we will narrowly avoid a meaningful recession is positive for corporate bonds issued by high-quality companies. These high-quality companies can continue to service their debt and hence their bonds should perform well, providing additional yield and attractive returns for investors.
This article was originally published in the Goodbody Investment Outlook 2024: Going for (structural) growth publication on 4 December 2023. To read the full Investment Outlook publication, click here.