Concerns over persistent inflation and increased government bond issuance mean bonds with a shorter date to maturity represent the best value right now, according to a pair of prominent fixed income investors.
The latest inflation data from both the US and UK showed small increases to 3 per cent in January, leading to concerns that global developed market inflation could prove more persistent than central banks had expected.
That is consequential for fixed income investors as stickier inflation reduces the scope for central banks to cut interest rates, while the spending power of the fixed income paid by a bond, known as a coupon or yield, is reduced as a result of the inflation rate.
Markets rushed in 2024 to reprice the prospects of rate cuts in the US and UK, which caused yields to rise and prices to fall.
Christopher Alwine, global head of credit at Vanguard, said: “For developed market bonds, the shorter end of the curve, that is bonds with a duration of 5-7 years, is where the value is right now. The US economy is fundamentally healthy, though inflation has proved to be stickier than expected.”
In contrast, he regards high yield bonds as unattractive at the current prices, having relatively little exposure there.
This was despite the relative health of the US economy, which tends to be positive for these risk assets as they can be more sensitive to the performance of the wider economy, but also meant spreads were tight right now.
Nicolas Trindade, senior fixed income fund manager at Axa Investment Managers, said he had substantial exposure to US Treasury Inflation Protected Securities (Tips), a type of US government bond with a coupon that rises with inflation, over concerns about inflation in the US.
He said: “European bonds have performed well so far this year simply because inflation seems to be under control there, and that should allow the European Central Bank to cut rates. We are not worried about inflation in the Eurozone area, but we are in the US, so duration wise we are underweight.”
Trindade is also underweight to high yield bonds based on concerns around valuations.
He said the reason high yield bond prices have remained so high, and therefore yields so low, despite the uncertain economic outlook in most of the world, was that “a lot of buyers in the bond market are income buyers. They care about the yield.”
Increased sovereign issuance
Another reason short duration is more appealing right now, according to Trindade, was an expectation governments would be forced to issue more bonds despite already very high debt levels.
This was in order to fund higher defence spending, spending on energy transition projects and health and social care.
The challenge this presents for bond investors is that if new bonds are constantly being issued, the value of government bonds already in the market may fall, particularly if the newly issued government bonds come to market with a higher coupon, or yield, than those already issued.
Trindade’s focus in the face of this problem is to stick with government bonds with a shorter date to maturity, as they would likely have matured by the time the impact of a new wave of government bond issuance is felt in the market.
Usually, when the market is anticipating cuts to interest rates, the appeal of owning government bonds increases, firstly because rate cuts typically happen when inflation is declining, and growth is declining, so investors are keen for the relative safety of government bonds.
But Trindade said at the current time “investors are going to have to get used to” greater levels of volatility associated with government bonds.
But Alwine added that the present relatively high yields on government bonds justified owning them.
david.thorpe@ft.com