Benstead on Bonds: why a ‘stealth’ bond bull market’s under way

On the surface, returns from bond markets this year are nothing to shout about. After moving sideways from January to June, fixed income has bounced back but is barely positive for the year, even when accounting for reinvesting coupons.

The ICE BofA Sterling Corporate index, which tracks credit issued in sterling, is up 3.6% so far this year, while an index of global bonds, the Bloomberg Global Aggregate, has risen just 1% in sterling terms.

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But the tide is turning and a “stealth” bond bull market has begun, according to one of the largest fixed-income managers globally.

PGIM Fixed Income, which oversees $805 billion (£616 billion) in bond assets, argues that attractive yields, impending interest rate cuts, and resilient corporate fundamentals contribute to a compelling outlook for bonds. All three are key to the appeal of fixed income – I explain why.

Inflation-busting yields

The yield-to-maturity on bonds, which factors in coupon distributions and the final principal payment when a bond matures, are one of the core reasons to invest in the asset class. But yields were squeezed as interest rates dropped to near-zero following the pandemic. However, as interest rates have risen, so have returns from bonds.

As of September, the yield on investment grade sterling bonds, which are very unlikely to default, is 5.2%. Gilts, where the default risk is effectively zero, yield between 3.5% and 4.3% depending on which maturity length you choose. Global higher-yielding “junk” bonds pay 7.6% in dollars.

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The yield of a bond is an accurate predictor of annualised returns, over long periods. Returning about 5% a year from safe corporate credit today, when the yield was just 1.5% in mid-2021, may look attractive to lots of risk-averse investors.

Schroders’ fixed-income fund managers say: “While bond yields are unlikely to return to their post-Global Financial Crisis lows, the opportunity in higher-quality fixed income remains compelling.

“Fixed income, for the first time in over a decade, offers high yields, and investors can build high-quality portfolios with yields over 5% without taking significant risks.”

Inflation is now near central bank 2% targets, meaning that the “real” or inflation-adjusted returns from bonds are attractive. To put 5% returns into perspective, UBS finds that over the past 123 years, global equities have provided an annualised “real” US dollar return of 5% versus 1.7% for bonds.

Put simply, if we can get a 5% annual return for bonds, then inflation would have to be 3.3% for returns to be in line with the average. I think inflation will be lower than that over the long run, so bonds to me look good value versus their history today.

Interest rate cuts under way

The other component that affects a bond’s return is the price movements of the bonds. If you own a bond fund, then the portfolio is constantly adding and selling bonds – it never matures as a bond owned directly would.

This means that coupons, plus the price return of a bond, generate your total return. Investors need to therefore think about the income from bonds as well as the outlook for bond prices.

The good news is that with inflation falling, and key central banks beginning to cut interest rates, bond prices are expected to rise. Moreover, they could rise when stocks fall, as when investors are worried they are drawn to the safety of bonds, where companies and governments are locked into coupon payments (unless they default). We have already seen this play out when stock markets wobbled this year, as I explained here.

Schroders says: “Even a modest rally in yields would create very competitive returns in fixed income, and we believe now is an opportune time to transition away from cash to lock in higher bond yields.”

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The fund manager’s view is that the likelihood of a “hard” landing in the US economy is increasing, now at a 20% probability as of August, compared with just a 5% chance before.

The fund manager made this change in outlook due to weakening manufacturing data and a softening US labour market. Weaker economic data means more interest rate cuts to stimulate economic activity.

Another optimist on bond prices is PGIM Fixed Income chief investment officer Gregory Peters. He adds: “The defensive characteristics of bonds at this point in the cycle are striking. If stocks experience a sharp correction while the Fed is on hold or cutting rates, bonds historically perform as solid shock absorbers in investors’ portfolios”.

Since June, bond markets have rallied strongly, as inflation fell back to central bank target ranges and traders priced in interest rate cuts. The Bank of England cut in August, while the US Federal Reserve is expected to cut this week.

Robust corporate health

A good outlook for bond prices, coupled with strong starting yields, make the case for the bonds.

However, an important consideration is how healthy companies are and whether a weakening economy will lead to defaults.

But analysts reckon that companies are in good nick and corporate bonds generally are well placed to deliver when economies slow.

Madeleine King, head of research and engagement at Legal & General Investment Management, says assuming the soft-landing narrative continues, we are likely to see credit upgrades outweigh downgrades over the next one to two years.

“Since we emerged from the Covid-19 pandemic, the fundamental quality of global credit markets has – on average – been on a consistently improving path. There was an initial rapid bounce-back, followed by a more gradual, prolonged period of recovery.

“Many originally investment grade (IG) companies that tipped into high-yield territory during the pandemic (so-called fallen angels) subsequently recovered and made it back into IG indices in 2022 and 2023. Indeed, the trend of elevated rising stars has continued this year, hitting a post-Covid peak in February 2024 on a 12-month rolling basis,” King said.

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Nevertheless, King’s team believes that over the next 12 to 18 months there will be more fallen angels than at any point since Covid-19.

“We still expect these to be slightly outweighed by rising stars, so there will probably be marginally improving credit quality on average.”

In order to witness a more systematic deterioration in credit quality, King thinks that a broad-based economic downturn would be needed. Her regular stress tests of the global credit investment universe suggest that over $350 billion of investment grade bonds are vulnerable to downgrades in the event of a global recession.

“To put this figure in context, this would be a slightly more benign outcome for bondholders than either the global financial crisis or the pandemic,” she concludes.