Frankfurt It was a terrible year for bonds, according to calculations by the British bank Barclays, the weakest in around four decades. High inflation, tightening monetary policy and the corresponding rise in interest rates put prices under pressure, as interest-bearing securities become less attractive as new bonds with better yields come onto the market. Because equities suffered equally, there was no good risk balancing in many portfolios.
In the meantime, however, there is two pieces of good news. On the one hand, interest-bearing securities have recovered somewhat since the beginning of the year; according to Deutsche Bank, Bunds even had their best week since at least 1990. And secondly, for the first time since 2014, nominal negative interest rates have disappeared worldwide. It is therefore more worthwhile to buy bonds simply because of the current interest. An overview of which this applies in particular.
The mood has brightened: the latest inflation data in the USA and Europe point to an easing. Accordingly, Richard Hodges, bond expert at Nomura Asset Management, finds the prospects “almost consistently positive”. He expects bonds to rise further if the central banks stop raising interest rates over the course of the year.
Investment Strategist Chris Iggo of Axa Investment Managers believes the US Fed and European Central Bank (ECB) are taking the pressure off in their fight against high prices in 2023: “The strongest rise in inflation rates may be behind us and looking ahead are interest rates already in the restrictive area”.
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In order to understand the complex events on the bond markets, you have to be clear: there are two issues here: interest rates – or more precisely: yields – and the economy. And these two themes can interact in different ways. When interest rates rise, prices fall in return, and the longer the term, the more, as was clearly shown in the past year.
Because if new securities with higher interest rates come onto the market, the price of the old securities must fall so far that the return – i.e. the current interest rate as a percentage of the price – is at the new level. In the case of securities with a long maturity, the effect of the price change on the return is spread over more years, it is diluted so to speak, so the price has to move all the more.
Different opinions on high yield bonds
However, bonds also react to the recession, which has an impact on the creditworthiness of companies. High-yield bonds are particularly dependent on the economy. Their price trends are therefore often similar to those of stocks: If there are no profits, this weakens the stocks and increases the risk of default for bonds.
Equities and bonds react similarly to rising interest rates like last year. This applies to a limited extent to corporate bonds in the face of a growing risk of recession. On the other hand, government bonds with top credit ratings benefit in economic crises from shifts from riskier investments such as high-yield and shares.
The opinions of experts on the economy are divided. Aviva Investors expects a “slight recession” in the most important industrial countries. Rich Clarida, chief economist at the US fund company Pimco, which belongs to the Allianz Group, sees a recession risk in connection with the policy of the US Federal Reserve (Fed).
He believes: “Under the current circumstances, it will be difficult to avert even a mild recession. The Fed’s tools are simple, the task is complex, and there are difficult tradeoffs to be made.”
There is a broad consensus that corporate bonds with good credit ratings are currently attractive. On the other hand, opinions differ on high-yield bonds, i.e. securities with weaker credit ratings, with many advising caution.
Generali Investment states: “2022 was the worst year in the history of the total return of investment grade bonds in the euro area, so that 2023 can start at a more attractive level”.
Bond expert Elisa Belgacem relies on European corporate bonds, which are rated more favorably than American ones. However, given the risk of a recession, she is wary of high-interest rates. According to their observations, this market was “almost closed” in the past year: the companies could hardly get rid of new bonds. If they want to make up for the deficit in 2023, that will depress prices.
Mathias Beil from Sutorbank takes a very similar view: He relies on bonds from “large companies with a dominant market position” with good credit ratings. Peter Lechner from DJE Kapital also agrees: “We are seeing a clear trend towards quality.” From his point of view, “government bonds or corporate bonds with an investment grade rating in US dollars or euros are the focus here”.
In the high-yield segment, he too advises caution in view of the increasing risk of default. In general, the default risks are “not insignificant”. Recently, papers from oil and commodity companies have performed well, as well as bonds from the health sector due to the aging of the population.
Axa IM’s Iggo says: “The best risk/reward trade-off is found in short-dated corporate bonds because the yields are attractive relative to duration and credit risk.” But he also finds high yield interesting: “The yields are high, the prices are high low and the risk of default is lower than in previous downturns.”
Bond again as a “safe haven”
In any case, the same applies to bonds as to shares: The overvaluation of previous years has been reduced as a result of the price slump, making entry more interesting again. The US fund company T. Rowe Price therefore sees the bond again as a “safe haven”.
It wasn’t that last year: the rise in interest rates sent interest-bearing securities and equities alike crashing. In 2023, things will probably look different. Then the main risk for stocks is not interest rates, but the recession. However, this increases the probability that stocks and good bonds will develop in opposite directions in moments of crisis, which reduces the risk of the entire portfolio.
Conclusion: Bonds can once again fulfill their function as a risk buffer in the portfolio and also contribute to current income again – with falling price dynamics, this may soon even apply to the real return calculated after deducting inflation.
More: How things might continue after inflation has peaked