Don’t be too quick to drop bonds in the sell-off: AXA IM

Investors should be wary of dumping bonds even though the asset class has been caught up in the sell-off that has dominated the start of the 2022, according to AXA Investment Managers.

Markets had been rattled over recent months by numerous concerns, including surging inflation, rising interest rates, worries about weaker economic growth and Russia’s invasion of Ukraine.

This had caused global equities to drop – the MSCI AC World index was currently down 16.1% (in US dollar terms) over 2022 so far. But investors had also become nervous in the bond market, with global treasuries falling 12.6% and corporate bonds down 13.8% over the same period.

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Falling bond prices meant yields had risen but they remained low when compared with current inflation and to their history, meaning that few investors were excited about fixed income at the moment.

Chris Iggo, chief investment officer for core investments at AXA IM, said the focus on relatively low yields should not mean investors overlook that bond prices are at multi-year lows.

“That means there is the potential for some interesting returns in the next year,” he added. “Bonds have sold off a lot and in previous bear market episodes, subsequent returns have been strong. So now is not the time to sell.”

One data point that Iggo highlighted was the weighted average price of bonds in fixed income indices: average prices have been well above 100 in recent years as interest rates fell below the coupon rates at which bonds were first issued.

“That is now reversing, and prices have fallen accordingly. What this means is that by either replicating a benchmark index or constructing a more concentrated portfolio, there is the opportunity to buy lots of bonds well below par,” he explained.

“On the assumption that most of them will redeem at 100, returns can be significant once the market turns. Pull-to-par, like compound interest, is one of the wonders of bond investing.”

For example, the average price of bonds in the Bank of America/ICE index had recently fallen to 90.6. Average prices had only fallen lower than this on a handful of occasions over the past 20 years – 2020’s initial COVID-19 sell-off (low of 78), the growth fears in 2015 (low of 84), the 2008-09 global financial crisis (low of 55) and the recession after the Y2K slowdown (low of 75).

Iggo added: “Each time, 12-to-24-month price returns were subsequently very strong. Prices may go lower, but they won’t stay low. Yes, default risk is rising, but active stock selection means that at the portfolio level this risk can be mitigated.”

The strategist said investors should look beyond the fact that bond yields in many cases are below the rate of inflation.

This is because bond prices move towards 100 the closer they get to redemption (known as ‘pull to par’), which benefits returns at the index level. In addition, new bonds will be issued with higher coupons to reflect rising inflation and rates.

“If interest expectations start to ease back this will provide an additional push higher in prices,” Iggo said.

“The total return could significantly beat inflation over the next couple of years even if the yield-to-maturity (which represents the annualised total return over the remaining life of the bond) may not look as though that would be the case.”

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