It's rare for bond managers to be excited about the prospects for their asset class – bonds were always meant to be boring.
But times have changed, and while that sadly hasn’t always been to everyone’s advantage (as the rollercoaster ride of that infamous "mini"-Budget illustrated), it’s time to seriously consider their role within an investment portfolio.
Interest rates are now the highest they have been in more than 15 years, a dynamic that has provided a boon for allocations to cash. The significant interest rate increases in the past two years has hit the bond market, leading investors to understandably seek refuge in money market funds.
However, with inflation fading and the interest rate cycle seemingly peaked, there are excellent opportunities in the bond market for both income and capital gains for years to come.
The last time interest rates were this high was in late 2006 and early 2007, however the current economic climate is very different. Economic growth is not booming, and interest rates are expected to decline.
The Bank of England is expected to cut interest rates soon, and while there’s never any guarantees this is generally very favourable for bond performance.
This is because yields tend to head lower after the first interest rate cut. For example, in the US, on average since the 1980s, the 10-year government bond yield has declined by almost 1 per cent on average in the 24 months after the first cut. Bond prices and yields behave like a seesaw: when bond yields fall, bond prices rise.
Uncertainty is a constant in markets, but taking a step back and looking at the return prospects for bonds, they appear attractive in most scenarios. For example, looking at one to five-year maturity corporate bonds, the current yield is more than 5 per cent.
Where things get interesting is if interest rates are cut: if bond yields declined by 1 per cent, you generate approximately an 8 per cent total return with significant income and capital gains.
A scenario where things could get a little messier would be a supply-side shock, which is much harder to navigate than demand-side shocks.
This is because they impact growth (down) and inflation (up) differently, which means the BoE would have to prioritise either stabilising inflation or growth. In such a scenario, both government bond yields and corporate bond yields could rise.
However, its worth noting to generate a negative total return over a one-year holding period you would need yields to rise by more than 2 per cent as the high starting yields help to cushion capital losses.
Where to focus?
We find short maturity investment-grade corporate and government bonds particularly appealing. These investments can deliver strong total returns in most scenarios.
Shorter maturity bonds are likely to benefit from interest rate cuts, as the yield curve typically steepens following the initial interest rate cut. This results in shorter maturity bond yields decreasing more than their longer maturity counterparts, which is favourable for bond returns.
