Capital Ideas^TM

Since the start of the year, the potential long term investment opportunity for fixed income has increased. Problems in the banking sector have raised the prospect that central banks will now pivot toward ensuring financial stability and either pause, or start cutting, rates. This increases the chances monetary policy could shift from a headwind for bond markets to overcome into a tailwind supporting results.

If central banks pause, then bond investors will continue to earn today’s high level of carry. If, on the other hand, central banks pivot and start cutting rates, fixed income markets would benefit from both the current high level of carry and the price appreciation from falling interest rates.

Even in a recessionary scenario, developed market bonds are expected to provide positive results. The only clear negative macro scenario would be if central banks were to resume aggressive interest rate hikes but in the current environment, this seems an unlikely outcome. The exact timing of any pivot is still uncertain, but with inflation showing signs of easing and lending standards never before this tight without a recession, the pressure on the Fed to pivot is increasing.

Against this backdrop, we think fixed income markets now provide an attractive investment opportunity offering potentially strong long term returns. Over a five-year investment horizon, we think returns in the region of 5-10% p.a. are now a reasonable expectation depending on the asset class risk.

In the near term, however, there is the potential for further periods of volatility, meaning that a cautious approach is warranted. Maintaining high levels of cash could now be expensive as markets tend to move ahead of any policy announcement. Instead, we think it is important for investors to remain flexible and use security selection to identify opportunities across the fixed income spectrum where value has been created.

This paper examines these potential scenarios and as monetary policy potentially becomes more favourable to bonds, looks at how investors can position their portfolios to capture any opportunities. In our view, diversifying and allocating flexibly across the major fixed income sectors could help investors to build more resilient portfolios with the potential for long-term attractive income and returns