Bond markets have become more attractive in certain areas amid a broad selloff to a number of segments. The author of this article examines where the opportunities lie.

The following commentary on the fixed income market comes at a time when bonds have been roiled by rising interest rates and inflation. Whatever the causes, the impact has been significant. For example, the S&P UK Investment Grade Corporate Bond Index has fallen more than 14 per cent over the past 12 months. 

To understand what’s going on, and how investors should position themselves, needs careful thought. A contribution to a discussion comes from Scott Ingham, investment director at Handelsbanken Wealth & Asset Management. The editors are pleased to share these views and invite responses. The editors don’t necessarily endorse all the views of guest writers. Jump into the conversation! Email tom.burroughes@wealthbriefing.com

It’s fair to say that the first half of 2022 – a period marked by interest rate rises and high inflation – has not been particularly fortuitous for bond markets. It’s easy to see why. bond prices generally fall when interest rates rise, and rising inflation erodes the real-world value of the returns paid on bonds (which tend to be fixed). However, despite all the noise, we believe that bond markets have steadily begun to present some more attractive opportunities for savvy investors.

Government bond markets have quietly begun to offer attractive returns
Investor views on government bonds are very dependent on their views on the outlook for the economy. As central banks attempt to slow down economic activity, interest rates are set to increase over the medium term. However, interest rates are likely to hit a natural ceiling as the economy slows down and inflation falls. Recession in the US is never impossible, but we believe that there is a relatively low probability of a serious economic downturn. There are also signs that – while pricing pressures continue to rise in the UK – inflation is probably at or close to peaking in the US. Reflecting this news, bond market pricing is already pointing to slower growth and more aggressive interest rate rises.

Against this backdrop, some government bonds look more attractive than they have done for some time. At more than 2 per cent at the time of writing, the yields currently being paid on 10-year government bonds in the UK have risen markedly since the lows of 2020 (when demand for bonds pushed prices higher and yields lower – close to 0 per cent). The yields on shorter-dated UK government debt, such as the 2-year bond, have also risen. Yields offered on US government bonds are currently higher still (of course, for UK investors buying US bonds, there are exchange rate risks here, as returns must be translated from dollars into sterling). Importantly, set against the returns available on cash savings, government bonds currently offer a compelling opportunity to capture a higher rate of financial return via a relatively low-risk investment.

Developed market government bonds at work in your investment strategies
-- At the moment, our government bond exposure remains relatively short-dated (i.e. we mainly hold bonds with a fairly short time left until they mature, and return capital to bond holders), cushioning our investment strategies from some of the near-term volatility in bond markets. Our bond positions are heavily skewed towards UK government debt, which we believe is relatively attractively priced.

-- We recently adjusted some of our UK government bond holdings, switching into longer-dated debt in an effort to improve our investment strategies’ tax efficiency. This meant moving to UK government bonds which pay lower coupons (often referred to as the ‘interest’ on a bond), but which are trading at less than their face value. These bonds have a higher anticipated overall return (if held until their maturity date). ‘Gains’ on the capital invested in these bonds are typically tax free for investors, with tax only paid on the regular coupon payments.
 

Developing economies present a range of risks, but are they worth it?
Investing in developing economies presents many unique and varied challenges. However, we would remind readers that no investment comes without risk: the important thing is to be aware of the risks you are taking on, and to be confident that the potential rewards available provide you with fair compensation for your risk taking.

For bond markets in developing economies, the potential for default (failing to make payments) is high on the list of risks. Earlier this year, amid its worst financial crisis in decades, the Sri Lankan government defaulted on its debt for the first time in history when it became unable to make coupon payments on bonds it had issued. The fact that this was deemed headline-worthy tells us that this turn of events is unusual, but it is not unthinkable.

In developing economies, a substantial hurdle for both governments and companies issuing debt into bond markets relates to exchange rates. This debt is often issued in US dollars rather than the local currency, removing direct local currency risks for bond holders, but increasing the risk of default. When the value of the US dollar rises relative to local currencies, it is much more challenging for bond issuers to make coupon payments, and to ultimately repay capital to bond holders when the debt matures.

Reflecting the risks investors take on by entering bond markets in developing economies, bond yields there are attractive – the yields offered on government debt are often around 7 per cent (though this naturally varies by country) and bonds issued by businesses offer even higher yields. In periods of crisis, such as the war in Ukraine, yields often spike higher, though they typically fall again in due course.

Bond markets in developing economies are as varied as the economies themselves, and certain areas present more attractive opportunities than others. When we invest on your behalf in developing economies, we are especially mindful of risks, potential reward, and overlooked segments of this diverse area of the market.

Developing market debt in our investment strategies
-- We hold high-yielding Asian corporate bonds across many of our investment strategies, seeing value in this ‘bombed out’ area. High-yielding debt in Asia is dominated by Chinese real estate. Defaults (including the high-profile case of Evergrande Group) became prevalent during the pandemic, when economic activity and property development dropped sharply, and China’s new regulations on company debt limits came into effect. As a result, bonds in this area are trading at very low prices. With prices reflecting what we believe to be an unduly negative scenario, we perceive an attractive investment opportunity.

-- A number of our investment strategies also hold a position in the Indian bond market. This is a local currency holding (so the bonds are priced/coupons paid in rupees), and have been performing well for our strategies. We continue to like the Indian bond market, which has reassuring barriers to entry and tends to behave quite differently versus other developing economy bond markets.