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Fixed income investment in the US market saw a clear recovery this year from the volatility of 2022, with many saying they expect to see it on firmer footing in 2024. But will this be as easy as relying on higher interest rates to provide higher yield?
In the US, a few categories saw poor results in the first half of this year; “for the year to date through June, investors have piled $90 billion into intermediate core bond and intermediate core-plus bond,” said Morningstar. It added that, as interest rates increased during the subsequent quarters, these categories fared poorly.
“Persistent inflation drove many of the economic challenges that institutional investors faced in the first half of 2023 as the Federal Reserve consistently raised interest rates and, subsequently, valuations in both equities and fixed income declined,” said Cerulli Associates in its “North American Institutional Markets 2023: Abundant Opportunities Despite Asset Declines” report.
“During the first half of 2023, fixed income assets, especially those with higher risk, recovered part of the losses of the previous year.”
Meanwhile, major insurers such as Travelers and Progressive ascribed their strong Q3 results to recovered fixed income investment income after a volatile 2022.
In Europe in fixed income markets, half-year results weren’t as bad as feared – with a drop of 0.2% compared to the 2022 results, which M&G Plc said in November was “thanks to a more supportive rate backdrop, while US [half year results] fell 1.2% and [Emerging markets half year results] declined 1.3%”.
“Floating rate half year benefited from its near-zero duration and was once again unaffected by the government bond sell-off,” M&G added.
But in the US, fixed income had been considered a slightly dangerous decision before the fears of a recession began to wane. “During the first half of the year, fixed income assets, especially those with higher risk, recovered part of the losses of the previous year,” said Beatriz Ranea, a fixed income manager at MAPFRE AM, which is part of MAPFRE.
”This was despite the volatility caused by geopolitical factors and the turmoil in the banking sector last April. Consequently, we have seen instances of corporate debt outperforming comparable sovereign debt," she added.
Many in the market now believed that fixed income would increase in popularity in 2024. Cerulli said that 68% of institutional investors it surveyed indicated that they would take advantage of higher interest rates and increase their allocations to public fixed-income investments
One of the key considerations for fixed income is what these trends mean more broadly for Q1 and H1 2024 in the US investment sphere – especially as the country heads into an election cycle when big financial decisions will likely be postponed.
This is of particular concern when the inflation and interest rate is taken into consideration.
“[In 2023], alongside the inevitable volatility, the prevailing question has been whether inflation has reached its highest point, and consequently, whether interest rates will continue their ascent or remain at that level, and for how long before they start to drop,” said Ranea.
Cerulli Associates said that according to its research, 70% of institutional investors expected to increase their allocations to actively managed fixed-income strategies over the next 24 months. It also found that 55% of institutional investors were responding to rising interest rates by increasing their allocations to alternative investments.
"If inflation proves stickier than expected, the Fed stands ready to
induce a recession to bring inflation down to 2%."
“This presents a significant opportunity for asset managers with strong fixed-income capabilities and performance,” says Chris Swansey, Senior Analyst at Cerulli.
Others said it was likely that inflation would be lower than expected heading into 2024, meaning there was less of a chance of it continuing to be a major factor.
Morningstar said in a recent report that it “expect[ed] inflation to average 1.8% from 2024 to 2027, undershooting the Fed’s 2% inflation target”. The report added that “if inflation proves stickier than expected, the Fed stands ready to induce a recession to bring inflation down to 2%".
However, as a result of the rise in interest rates, guaranteed funds have become attractive. But for how long? This is now the question. “Yes, [guaranteed funds] are attractive,” said Ranea. “Investors who hold to maturity are assured not only of recovering the full amount of their initial investment but can also earn an additional fixed or variable return, depending on the product.”
Ranea said that public debt core countries with lower debt-to-GDP ratios would be one of the best bets for investors in 2024.
“In corporate debt, there is still value in financial entities, which suffered more than non-financial entities in 2022,” she said. “The incident that occurred in April of this year, involving the failures of Silicon Valley Bank, Signature Bank, and First Republic Bank in the US, and the resolution of Credit Suisse, illustrated that the likelihood of contagion is minimal.”
She also stressed balance sheet detail and taking long-term considerations into account. “Since the 2008 financial crisis, balance sheet repair has been done well in many cases, regulators are more vigilant, and capital levels are adequate,” she said. “Within non-financial entities, the tightening of financing conditions and the risk of an economic slowdown should take their toll.”
“[In] our approach, the most attractively valued markets are
currently Mexico, New Zealand, UK, and the US.”
As the market’s prospective real yield is defined as its 10-year government bond yield minus any inflation forecasted for that market and sovereign credit risk, there could be interesting trends ahead, said a representative from asset manager Mondrian’s fixed income team.
“The dispersion of prospective real yield is currently at a 10-year peak in developed markets,” said Mondrian. “Therefore, we believe it is crucial to take an active approach and be highly selective with country positioning for global bond portfolios. When dispersions are wide, it can signal dislocations in the market."
They added that certain markets had caught their eye to invest in due to these anomalous conditions. “[In] our approach, the most attractively valued markets are currently Mexico, New Zealand, UK, and the US.”
According to Fitch Ratings’s US life insurance investment portfolio review, 67% of this was in bonds, which highlighted the overwhelming importance of fixed income to US investment portfolios.
“Insurers are benefitting from reinvesting in a rising rate environment on reinvestments and can generally benefit from opportunistic sales of fixed income securities prior to maturity,” said Fitch.
With interest rates and inflation at an impasse (at worse) and inflation falling and at least one cut to interest rates expected in 2024 (at best), most experts see fixed income’s fortunes rising as a mainstay in investment portfolios.
