Of all the predictions made for markets in 2023, one was near unanimous among large fund groups – that bonds would return to form after a bruising 2022 when interest rate rises caused bond prices to plummet in value.
But until just two months ago, investors who backed fixed income were left red-faced, as stickier than expected inflation and the assumption that interest rates would be “higher for longer” caused investors to keep selling bonds, pushing up yields even further.
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The Bloomberg Global Aggregate, a large basket of developed market corporate and government bonds that can be used as a general measure for the global bond market, fell 6% in sterling terms, including the reinvestment of income, up to mid-August last year. It moved sideways until November, when a sudden rebound saw it erase all its losses for the year – although a loss in real terms when factoring in inflation. Returns in dollars were worse, but a strengthening pound in 2023 helped offset some of those losses for UK-based investors.
So, what happened in November that turned another bad year for bonds around? It was all about the “pivot” from central banks. Whereas for most of the year central bankers were talking a tough game on inflation and interest rates, saying that the battle against rising prices was far from won and rates would stay high for the foreseeable future, the messaging turned in December and was prompted a month or so before by investors.
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The US Federal Reserve, which sets the tone for what central bankers around the world do, revealed in its 13 December meeting that it expected to cut rates three times next year. Its view was that inflation was meaningfully lower (at just over 3%), which gives it room to stimulate the economy with less risk of restarting an inflationary cycle.
Traders are pricing about 1.5 percentage points of rate cuts in the US and UK in 2024, and around 1.7 percentage points of cuts in the Eurozone, according to Bloomberg.
Reuters reported that in December eight of the central banks overseeing the 10 most heavily traded currencies held rate-setting meetings. Seven of the eight held rates where they were, and only Norway increased interest rates.
Markets therefore believe that a corner has been turned, and interest rates will begin to fall this year to help prop up slowing economies, which could be great news for bond prices.
The real question for bond investors is that with so much good news priced in, have investors got ahead of themselves, and what could ruin the party?
Will bonds make a good investment in 2024?
Bond fund returns come from two sources: price changes and interest earned. The second part of that equation is key as the new year begins, according to Craig Macdonald, global head of fixed income at fund manager abrdn. He says the yields investors can get are still high, which is “always a good starting point”.
As of the start of January, providing the bonds are held to maturity investors buying a 10-year UK gilt will get an annualised return of 3.65%, and those buying a US 10-year government bond can pick up nearly 4%. Bonds maturing sooner yield even more, one and two-year gilts yielding 4.7% and 4%, and one and two-year US treasuries yielding 4.8% and 4.3%, according to data from MarketWatch.
Corporate bonds, due to the extra risk involved, yield more, with the S&P UK Investment Grade Corporate Bond index yielding 5.25%.
The outlook for the other part of the equation, price rises, also looks good for Macdonald. He says that inflation is finally coming down, which means interest rates in large economies such as the US, Europe and UK have likely peaked.
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“However, to turbocharge bond returns, central banks will need to start cutting interest rates by the second half of next year.
“If we look at the historical relationship between interest-rate cutting cycles by the US Federal Reserve and bond performance, the periods following peak interest rates have led to strong returns in many parts of fixed income,” he said.
So, how likely are rate cuts next year? Macdonald says that on the one hand higher debt-servicing costs, shrinking central bank balance sheets and tight lending conditions are having an impact on economic growth, which would support rate cuts. But he adds that this has been more than offset by the excess savings people built up during Covid lockdowns and a strong jobs market, which has supported a stronger-than-expected global economy.
However, he says that these excess savings will have mostly gone by the end of 2023 in countries such as the US, and we are already seeing increasing auto loan and credit card defaults due to higher borrowing costs.
“This suggests consumer strength will diminish quite quickly next year. Taken together, we should see an environment in which inflation falls further, the job market weakens slightly and the economy slows to a recession, or at least something that feels like a recession for many companies and countries.
“When central bankers see that economies have slowed enough to bring inflation back to their target levels, they will cut interest rates – a move that will support many areas of the bond market,” Macdonald said.
One of abrdn’s top picks in the bond sector are higher-quality bonds, which Macdonald argues will benefit from abrdn's “most likely” scenario of slowing economic growth, lower inflation and central bank interest rates cuts.
The big risk to his base case is that unexpected economic resilience and a resurgence in inflation forces central banks to raise interest rates again.
“This would be bad for most asset classes other than bonds with shorter tenors and money market funds,” Macdonald said.
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What about the longer-term outlook for bonds?
While predictions about market returns over a 12-month period are notoriously unreliable, taking a longer-term perspective, based on historical data, can lead to more accurate forecasting.
Vanguard, the US indexing giant, in its outlook for fixed income in 2024 and beyond said that “bonds are back” and it now expects US bonds to return an annualised 4.8%–5.8% over the next decade. This compares very favourably with the 1.5%–2.5% it expected before the rate-hiking cycle began at the end of 2021.
For international bonds, it expects annualised returns of 4.7%–5.7% over the next decade, compared with a forecast of 1.3%–2.3% when rates were low or, in some cases, negative.
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This shows that higher interest rates have provided a fantastic reset for bond investors, and expected returns are now substantially higher than before the rate-rising cycle began in late 2021.
And with inflation heading back towards central bank targets of 2%, the “real” or inflation-adjusted return from bonds looks appealing.
UK CPI inflation is currently 3.9% for the year to November 2023, down from 4.6% in the 12 months to October, while US inflation is at 3.1% for November. A return to 2% inflation is in sight, with the US and UK central banks expecting it to hit that figure by the end of 2025.
To put that into perspective, Allianz Global Investors calculates that UK inflation has averaged 2.4% a year for the past 25 years, meaning that inflation is very close to being back to “normal”.
So, even if 2024 underwhelms in terms of bond price rises, the income on offer and the positive longer-term outlook for the asset class should reward investors looking to add some defensive assets alongside their equity allocations.
