Bond fund managers prepare for interest rate cuts in 2024

Morningstar Wealth has recently released its 2024 outlook addressing the key issues on investors’ minds. One opportunity highlighted was “Taking Advantage of the 5%-plus Rates Reset” .

This reset had caused significant price falls in asset classes that were historically considered “low-risk” by textbook definitions - including the US 10+ Year Treasury Bond Index, which was down -41.7% from 31 July 2020 to 15 November 2023. However, the material increase in bond yields has improved forward-looking prospects, particularly in developed markets where yields now cover inflation in many instances, offering positive “real” yields.

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In the case of the US, Morningstar’s economic outlook is on the optimistic side relative to consensus, with a base case for the US that involves no recession and inflation falling back to central bank targets, otherwise known as a soft landing.

Government bonds look attractive across the yield curve (bonds with different lifespan lengths), and Morningstar advocates being overweight versus corporate bonds, where spreads (difference in yield) remains tight in both investment grade and high yield. Therefore, there’s greater risk in a scenario of economic deterioration. That said, they do have a place in a portfolio given their yield pick-up over government bonds.

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So, how does Morningstar’s fixed income view compare with those of the flexible bond managers on interactive investor’s Super 60?

Where two flexible bond funds are finding value

M&G Global Macro Bond is a “go-anywhere” strategy and is the most flexible within M&G's suite of retail bond products, managed by Jim Leaviss and Eva Sun-Wai. The managers have been de-risking their portfolio over the course of the year as bonds yields moved higher. Leaviss points to the likelihood of being at peak interest rates, and in this scenario over history, US government bond yields typically come down aggressively within 12 months as central banks have to start cutting rates.

He also points out that the US government bond market is very cheap relative to history. The fund is light in higher-risk areas of the bond market due to little upside (the extra yield versus lower-risk bonds does not compensate enough) in the uncertain environment, particularly so in high yield. Here they have been buying protection via credit default swap indices, and only 8% net exposure in investment grade bonds. Developed market government bond exposure currently stands at 55%, the bulk of which is invested in US government bonds, with the remainder in UK and European countries.

The Super 60’s other flexible bond strategy is Jupiter Strategic Bond managed by Ariel Bezalel and Harry Richards. Their key thesis is similar, which is that major developed market economies are going to see a material slowdown and most likely a recession. The duo think this will entail rate cuts sooner rather than later.

On this basis the managers see high-quality government bonds as the best shelter for a hard landing, and they see material value here, particularly in the US, Australia and in some emerging markets. They note the advantage of a high duration stance (owning bonds with longer lifespans and more sensitivity to interest rate changes) in the current conditions. But the duo also see meaningful value elsewhere and advocate a fairly diversified stance in terms of maturities, similar to Morningstar.

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In a similar sentiment to M&G, they believe corporate bond markets look complacent with mounting recessionary risks but are still willing to have exposure in the short term. They are less bearish on high yield as they continue to see value in more defensive sectors such as telecommunications, healthcare and consumer staples, and have been rotating out of cyclical sectors that are more exposed to consumer behaviour.

So, overall, unlike Morningstar, both managers expect a recession, but all three outlooks point to rate cuts in 2024 and advocate meaningful government bond exposure in portfolios.

Andrew Jayne, is associate director of manager selection, at Morningstar Investment Management Europe.