The comeback of bonds

For a long time, the asset class of bonds enjoyed great popularity among professional and private investors due to its broad stability and not infrequently served as risk mitigation and diversification in portfolios. However, inflation and rising market interest rates triggered a broad sell-off in the bond market this year, abruptly ending a bull market that had lasted for three decades. Now, however, it could be a good time to get back in, which is not only reflected in the rise in yields on interest-bearing securities. In the following Q&A on the situation on the bond markets, we explain why this is so and what investors should pay attention to in the current market environment.

Peter Lechner is co-fund manager of the DWS Concept DJE Alpha Renten Global, of the DJE - Short Term Bond and other institutional special funds.

Where is the current upswing for the bond asset class coming from?

The background for the higher interest rates is the restrictive monetary policy course of the central banks, which is based on the strongly increased inflation rates. Their rise is in turn related to the exploding energy prices.

This is primarily due to the war in Ukraine. However, the picture is not uniform: in Europe, for example, it is primarily the scarce supply of oil and gas that is responsible for the currently still high inflation rates. In the USA, on the other hand, we are dealing with demand-driven inflation due to increased wage costs and a declining savings rate. Although the US Fed is well ahead of the European Central Bank ECB in raising interest rates, the Europeans are now following suit. The bond asset class is currently benefiting from the fact that new coupons with higher interest rates are now coming onto the market, which makes them much more interesting for investors. In addition, many interest-bearing securities look attractive again after the price losses this year.

What should investors basically look out for in order to benefit from the increased interest rates and yields?

We see a clear trend towards quality: government bonds or corporate bonds with investment grade ratings in US dollars or euros are in focus here. On the other hand, one should be more cautious in the area of high yield in view of higher probabilities for default risks (CDS development). In addition, one should not completely disregard the yield curves: Here we see that in the USA, for example, the interest rates for short-dated bonds are higher than for long-dated papers. The inverse picture is also similar in Europe. In the past, this was always an indicator that a recession was imminent. If the probability of this increases, this argues in favour of buying bonds with longer maturities, as interest rates there fall across the entire curve in the event of a recession, which in turn means price gains, especially for long-dated paper.

Which sectors and industries have performed well recently?

Bonds from the oil and gas sector have recently performed exceptionally well, as they were able to profit from the price increases in the commodities sector. But bonds from the pharmaceutical sector have also performed well in view of the demographic development in the industrialised countries. However, we also look at cyclical automotive suppliers after in-depth analysis by our in-house research. The same applies to the airline sector.

How do you assess the current credit default risk?

We currently assess the default risks as not insignificant. A look at producer prices shows that some producers have to pay significantly more for their primary products. Many industries are also undergoing profound change, be it due to digitalisation or the shortage of skilled workers. Due to these developments, we are particularly selective in our choice of high-yield securities.

How high do you assess the risk of a new euro crisis in view of the increased interest rates?

Currently, we assess the risk of a renewed euro crisis as moderate. With the Transmission Protection Instrument, TPI for short, the ECB has created a new tool with which it can control the spreads between German Bunds and bonds of the European periphery states - which has already been done with the sale of German and Dutch government bonds and the purchase of Italian and Spanish papers.

Where are interest rates heading to?

In the USA, it became apparent that the Fed took the pace out of interest rate hikes at its last meeting.  A rate hike of 50 basis points was decided. Further rate hikes are conceivable, as the Fed does not yet see itself as having reached its goal in the fight against inflation. Consequently, the Fed funds rate could move towards 5% next year. Although the Fed's measures currently clearly focus on fighting inflation, the goal here is also likely to be a soft landing of the economy. In the coming year, we can imagine inflation in the US falling back to a corridor of three to four percent.

Since the inflation rate in the Eurozone is even higher than in the USA, it is apparent that the ECB is still behind the curve in the fight against price increases. We estimate an inflation rate of four to five per cent in the eurozone as realistic for 2023. Nevertheless, we can imagine that the key interest rate in Europe could be beyond three percent at the end of the first quarter or in the second quarter of 2023.

How do you assess the further development on the bond markets?

The development of spreads or risk premiums of high-quality corporate bonds compared to government securities should remain relatively stable in the event of only a mild recession, while they could widen in the high-yield segment. The development of the economy plays a decisive role here.

A special situation could arise in Japan. The Bank of Japan is not only facing a change in leadership next year, but possibly also a partial departure from its decades-long low interest rate policy, or at least from the existing practice of yield curve control. Here, however, a very cautious change of direction on the part of the Bank of Japan is to be expected. Consequently, the yen could slowly regain strength.

What events could affect the bond markets in the coming year?

Geopolitical crises tend to have a negative impact on the equity markets and could prompt investors to withdraw capital from the equity market and shift to the safe haven of (government) bonds. Such a scenario could lead to a significant decline in government bond yields. It remains to be seen how far the central banks will go with interest rate hikes in view of the recession scenario. The emerging opening strategy of the zero-covid policy in China is likely to have a demand-increasing effect on the oil market, which would, however, in turn increase inflation in the USA and Europe

How can you build a robust bond portfolio in the face of so many risk scenarios?

The basis of a robust bond portfolio is a detailed security selection, whereby we rely equally on a strategic and a tactical component. The strategic component would be a diversified base portfolio of government and corporate bonds with good credit ratings (investment grade). With regard to the tactical selection, one looks for special situations in the market to which one must react. One example is the underwriting of promising new issues.

Another tactical adjustment screw is the market-phase-dependent control of the currency exposure as well as the duration by means of overlay management. In our view, buy and hold is not a suitable strategy; instead, as an active manager, we aim to generate additional performance through overlay management. This also means, within the framework of active risk management, to quickly dispose of positions that are no longer appropriate for the portfolio mix.

If you had to give the bond year 2022 a label: What does it say?

Looking at the year 2022, one has to speak of a "bond crash" due to the unusually strong and rapid rise in interest rates. The upcoming year 2023, on the other hand, could be described as "yes, but". Investors should not disregard bonds. The focus should be on issuers with solid credit ratings that have a good market position and a good chance of surviving a recession. However, investors need to be aware that in view of inflation, the current interest rate hike cycles are not over yet.  But if inflation declines, a rally in the bond market cannot be ruled out.

 

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