The bulk of returns from bonds is likely to come from the income generated, rather than capital gains in the year ahead, according to several prominent market participants.
Iain Stealey, a bond investor at JP Morgan Asset Management, says the challenge that investors have faced since rates began to rise in the US is that, while the yield available has risen, the potential for further rate rises creates the risk that bond prices could fall, causing losses greater than the gains available from the higher income paid on the bonds.
Stealey’s view is that with interest rates in global developed markets unlikely to rise from here, “that risk has been removed”.
While there may not be much capacity for bond prices to rise as much has, in his opinion, already been priced in, “you can enjoy the nice yields knowing the risk of further rate hikes has been taken away.
"Also, you have optionality that, if the economy does turn down, which we don’t expect, then bond prices may rise and that is where the capital gains may come in.”
He anticipates that for the rest of this year, and potentially into next year, the income available from a bond, known as “carry”, will be the main driver of returns.
Indications of cuts
Stealey’s view that there may not be much room for capital gains from bonds in the near term is based on two factors.
The first is that he believes current economic data is positive, and doesn’t point to a recession, reducing the potential for bonds to be a safe haven.
The second is that he believes the sharp rally in bond prices in the final quarter of 2023 “was a sign of too much enthusiasm” among investors as they began to price in up to six rate cuts.
Stealey says the US Federal Reserve has indicated that three rate cuts are likely at some point this year, and the bond market is now priced for close to this level, implying bond prices may be close to fair value, as long as no significant economic downturn occurs.
His view is that an economic “soft landing” has already happened, and that rate cuts have the potential to extend the period of economic positivity.
Roman Gaiser, head of fixed income at Columbia Threadneedle Investments, is another who is keen to focus on the higher yields available from bonds, particularly government bonds.
He says his focus has been to “lock in the yields for as long as possible”, and with that in mind has exposure to bonds with a long date to maturity.
With that in mind, he is relatively cautious about taking credit risk - such as buying bonds that have a credit rating of below investment grade - as he anticipates defaults will rise.
