Global equities, as measured by the MSCI World Index, have delivered an annualised return of about 4.8 per cent since 2000.
Not bad, but investors can now lock in coupon payments from global credit at yields close to historical equity returns without equity risk factors.
To us, this looks like a new golden age for bonds.
When corporate bond yields began climbing rapidly at the start of 2022, it created difficulty for many market participants. However, this rise sets the stage for bond investors to reap higher levels of income than previously available.
Here’s why: currently, the average investment grade corporate yield, as measured by the S&P Global Developed Corporate Bond Index, is around 5.1 per cent. Meanwhile, high-yield corporate bonds, as measured by the S&P US Dollar Global High Yield Corporate Bond Index, yield around 8.3 per cent. Both currently out-yield global equities which are delivering 1.8 per cent.
Critically, many corporate issuers have funding costs well below current market yields, so they have been insulated from the rise in rates. That’s because 62 per cent of investment-grade corporate bonds and 69 per cent of high-yield bonds were issued before 2022.
While a bond investor should care about yield and not typically make issuance year a focus, this dynamic provides some cushion of safety to bond investors as the cost of corporate funding is rising slowly as bonds mature and need to be refinanced.
This sets up the potential for a win-win for bond investors and the companies in which they invest: a win for the investor because they can harvest today’s higher yields from high-quality companies, and for many corporations as they can comfortably service their debts at pre-2022 coupon levels. With rate cuts nearly upon us, the rates environment should become friendlier for corporate refinancing in the years ahead, in our view.
Lopsided equity opportunities
At the same time we are seeing this potential win-win for bond investors, equity markets are becoming increasingly lopsided, and dominated by a small number of US companies.
The outperformance of mega-cap tech stocks, led by the Magnificent-7 (Alphabet, Apple, Amazon, Meta, Microsoft, Nvidia and Tesla) has resulted in a huge divergence between the MSCI World US Index and the MSCI World ex-US Index, and US equities have grown to over 70 per cent of the MSCI World Index.
Although the ascent of the Magnificent-7 has reflected a period of exceptional earnings growth, their dominance means many equity investors are now more concentrated than they may realise.
Notably global equities rose in Q2 this year, but this was mostly driven by only two sectors (Information Technology and Communication Services). In fact, the percentage of companies in the MSCI World Index whose price is above their 100-day moving average fell during Q2 from 80 per cent to just above 50 per cent.
Active or passive bonds?
Given where we are in the economic cycle, plus the political landscape, we expect volatility to increase; this should create plenty of market dislocations to exploit. That’s why we believe now is a good time to be active in fixed income.
The rise of passive investing in the last decade has dramatically reduced the cost of investing in bonds, but it has also created significant inefficiencies for active bond investors to exploit, as comparatively less active money has been available to arbitrage away relative or absolute value opportunities.
A key risk for passive bond investing is that fixed-income benchmarks are fundamentally flawed in a way that equity indexes aren’t. Unlike equity indexes, bond indices tend to apply weightings based on debt outstanding.
This can mean passive bond investors are unintentionally overweight and overexposed to more heavily indebted companies.
Relative value opportunities
An active approach to bond investing allows intentional tilts in favour of bonds backed by companies with strong credit characteristics and those at an attractive valuation, among other risk factor tilts. A savvy bond investor can also exploit inefficiencies that arise from large index-tracking strategies that are focused on closely tracking a benchmark, rather than risk-adjusted return generation.
Targeting inefficiencies effectively means casting a wide net across the fixed-income universe, including corporates,
governments, municipals, mortgage-backed securities, global bonds, emerging markets, and structured credit, and combining the best opportunities with precise risk scaling.
Market inefficiencies are often durable but not large. Most notably, the risk premium available on individual bonds can be inefficiently priced, allowing credit-focused managers to target multiple security-selection opportunities.
We believe managers need to be resourceful enough to find inefficiencies across the whole fixed-income universe, such as employing credit analysts across the globe. However, they also need to be nimble to have any hope of exploiting them (for example, by managing strategies small enough to take a security or sector-selection position that can have a meaningful impact on performance).
Conclusion
In our view, it is time for investors to increase their allocations to fixed income. The rise in yields has created an opportunity to lock in attractive income streams for the long-term. Fixed income assets have historically been significantly less volatile than equities, experiencing shallower drawdowns with faster recoveries.
This helps to allow investors to achieve their long-term objectives with greater certainty via more reliable, income-driven returns.
Bonds might lack the glamour and buzz of many of the investment trends of the last decade, but they have the potential income, return, risk profile and staying power many are seeking. Welcome to the new golden age of bond investing.
Adam Whiteley is head of global credit at Insight Investment
