1 min read 6 Nov 23
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Investing involves risk, including the loss of principal. Where any performance is mentioned, please note that past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.
Monetary policy works with a lag. The sharp increase in liquidity we experienced around the COVID-19 pandemic led to a resurgence of inflation about 18 months later. Central banks have now reversed course, causing money supply to fall, and this in turn will continue to put downward pressure on inflation. For investors, this means central banks are at the end (or very near the end) of their tightening cycle. This, we suggest, has created an attractive risk-reward opportunity for duration-bearing assets. We think is even more relevant given the historically high starting yields of many core government bonds.
September saw the European Central Bank nudge rates to 4%, their highest since the launch of the euro in 1999. Meanwhile, the Bank of England kept rates at 5.25% (a rate akin to 2008 levels!) while the Federal Reserve maintained rates at a two-decade high (5.25-5.50%)
Duration is starting to look attractive to us. We believe that owning duration is attractive: the downside is limited, as in our view rates are close to the peak, while the potential upside is good, as this time around central banks have room to cut rates significantly. We continue to scale into boosting duration risk because of the value attached; e.g., move duration away from euro assets, back into US dollar assets as US Treasuries underperformed and are now looking relatively more attractive.
While cash might appear relatively attractive today with interest rates at multi-year highs, it may soon lose its appeal if rates were to fall as investors would have to reinvest at a potentially much lower yield.
Based on the scenario below, should interest rates remain range-bound, we could still benefit from the higher coupon offered by owning duration today. However, if rates were to fall we could be in a strong position to benefit from rising bond prices (see Figure 1). So, in our view, owning more duration than we have owned historically makes sense from a risk-reward position.
Source: Bloomberg, 30 September 2023. Scenarios are an estimation by the M&G team and not a guarantee of future results.
Until 2021, we were living in an environment of extremely low interest rates. As a result, many investors shifted their allocation towards equity, as that was considered to be the only way to generate some attractive returns. However, things have now changed considerably. Fixed income is finally back, providing investors with a valid alternative to stocks. Even more so if we look at valuations (see Figure 2). The expected yield from fixed income investing is now looking more attractive than the one provided by stocks. So in some respects we’ve gone from ‘There Is No Alternative’ (TINA) to ‘There Is an Alternative’ (TIA).
Past performance is not a guide to future performance
Source: Bloomberg, 30 September 2023. *12m Forward Earning Yield (EY); YTM = yield to maturity
As we move towards the latter part of the cycle, we believe a flexible and diversified approach will be crucial. While tighter spreads and rising macroeconomic risks pushed us to reduce our credit risk to a more neutral stance, we continue to look for opportunities to explore dislocations in credit markets and occasionally we get involved in the primary market, where we can find new deals with attractive premiums.