Difficult to avoid recession, but global bonds finally attractive
Jim Leaviss, Chief Investment Officer of Public Fixed Income at M&G Investments
It will be difficult to avoid a global recession in 2023, and the recent surge in global bond yields is already reflecting the market’s expectation of a significant economic downturn next year.
The good news for investors, however, is that all types of global bonds – government and corporate, high- and low-quality – are now looking attractive for investors, even with a likely recession looming.
Central banks’ aggressive interest rate hikes have already had a dramatic impact on global growth. Almost every US recession since the 1970s has been preceded by a sharp spike in the oil price, which resulted in a familiar pattern of broader rising inflation, steep interest rate hikes to suppress price pressures, and subsequent contractions in economic activity.
However, there are reasons why this recession might not be as deep as previous downturns: among others, the global economy is now less energy-intensive than in the past; and governments are keen to use spending to boost their economies even as central banks are tightening monetary policy, which hasn’t been the case for decades.
The US, in particular, is likely to emerge in a better condition than Europe and the UK due to its stronger underlying growth, more flexible economy and resilient labour market, among other factors.
Opportunity for “super-normal” returns from global bonds
Looking at current global bond market conditions, following this year’s sharp sell-off, both government and corporate bonds now offer opportunities for investors to earn “super-normal” returns.
US dollar global investment-grade (IG) and high-yield (HY) corporate bonds are trading at their highest yields in 10 years: IG five-year bonds yielding 4.8%, compared to only 2% just last year — this was higher than during the Covid-19 pandemic. Meanwhile, HY corporate bonds (those with credit ratings of BB or lower) were offering around 9.0%.
On the four occasions since 2012 when global corporate bonds yields were trading at similar levels, IG bonds returned between 7.5% and 12% over the subsequent one-year period, and HY bonds returned between 9% and 17%. Investors finally had a good opportunity to add bonds to their portfolios for both income and diversification purposes after a long period of offering negative returns.
As for the risk of default in IG corporate bonds, M&G Investments credit research and historic default behaviour showed that this risk was “negligible”, at less than 1%. In the riskier HY bond market, the cumulative five-year default rate is 15%, but the market is currently pricing in an exceptionally high 35% default rate, the most elevated level in 52 years and high even in the event of a serious recession.
In M&G’s view, the current HY bond yields should more than compensate investors for the default risk involved in a recession over the next year. Another risk for bond holders, that of high inflation eroding bond returns, is indeed a worrying factor for investors over the shorter-term.
However, this is not likely to be a significant detractor for long. This is because inflation is expected to fall fairly quickly as a result of both high base effects, and the full impact of the most recent interest rate hikes and those yet to come.
Investors who buy now and hold their bonds over time will earn attractive returns. In fact, M&G Investments has recently bought US dollar global IG and HY corporate bonds for client portfolios, including those in South Africa, after having held none for a long period.
However, we did not go “all in” to buy up maximum bond exposure because of the still-existing risks and our desire to keep cash available for future opportunities.
In our view, valuations are attractive on an historic basis across government, investment-grade, and high-yield bonds, and we have started to take advantage of this. Investors can expect market volatility to remain elevated as markets continue to weigh the likelihood and severity of a recession ahead, and central banks respond to data and adjust their monetary tightening measures and outlook accordingly. It is a very news-driven market. Despite this uncertainty, we are confident that investors who buy now and patiently hold these assets are likely to reap the benefits of diversification and a steady income over time.
ENDS
