Rethinking Bonds: Why Fixed Income Should Be on Your Radar Today
The Reserve Bank of Australia (RBA) kept policy rates on hold at 4.35% in June, a level PIMCO believes to be materially tight. This tightness is evident in the percentage of household income allocated to mortgage payments, which has significantly slowed economic growth. The labour market is gradually loosening, wage growth is slowing, and first quarter GDP grew by just 0.1%, suggesting the economy is teetering on the edge of a recession. Over time, this tight policy should pull inflation back down to the RBA's target range and allow the RBA to begin its easing cycle.
The market is pricing in the first rate cut for next year, but we believe that waiting for that to happen before moving out of cash and into fixed income could mean missing out on potential gains. With the challenges bonds faced in 2022 still fresh in many investors' minds, it's essential to separate myths from reality and recognise the opportunities that bonds offer in the years ahead.
Global easing cycle has begun: Why waiting for the RBA to cut rates might not be prudent
Several central banks, including those in Canada, Europe, Sweden and Switzerland, have already started cutting rates, indicating that the global easing cycle has begun. When it comes to duration positioning or exposure to interest rates, at this point in the cycle PIMCO prefers economies where borrowers have been subject to floating-rate loans and there is a faster pass-through of tighter monetary policy. Sharp increases in policy rates mean these borrowers face rapidly increasing interest payments and this, in turn, directly impacts spending and activity across the broader economy. So we expect it is only a matter of time before countries like the UK, Australia and New Zealand also begin easing cycles.
However, investors waiting for the first RBA rate cut risk missing out on the period of strongest performance for bonds. Historical trends indicate that the most significant gains in fixed income markets often occur before, not after, interest rates have peaked (see chart).
Bond returns begin to outperform cash before cash rates peak
Hiking cycles are defined as periods where the Reserve Bank of Australia embarks on a sustained path of increasing the target cash rate. We define the end of a hiking cycle as the month where the RBA reaches its peak policy rate for that cycle (i.e., it either pauses rate hikes or cuts). Hiking cycles include (start to peak) 2001 (Dec '98 to Jan '01), 2008 (Oct '01 to Aug '08), 2011 (Apr '09 to Oct '11), 2024 (Jun '22 to May '24). This chart includes data for the most recent hiking cycle, ending May 2024, for the periods -12 to -24mos prior to peak, defining May 2024 as the peak policy rate.
Starting yields matter: Why 2022 was an outlier for bonds
One of the most critical aspects of fixed income investing is the starting yield. The starting yield on your portfolio today is a strong indicator of the return you can expect on that portfolio over the next three to five years.
In 2022, starting yields were low, leading to less attractive returns. However, 2023 saw positive returns for bonds, reflecting the higher starting yields.
Looking at historical trends, 2022 was an anomaly in the bond market's history. With rates now having reset higher, expected returns going forward are also higher, presenting a compelling income proposition.
It’s worth noting that although the bond market has undergone this repricing with yields resetting higher, other asset classes have not yet followed. Equities are still near their highs, credit spreads remain reasonably tight, and commodities have been strong for some time. This makes bonds a compelling option for de-risking portfolios as the economy starts to slow.
Now is the time to lock in fixed income returns
The fixed income market today offers compelling opportunities for investors willing to look beyond recent volatility. Rather than basing bond return expectations on the anomalous experience of 2022, investors should consider 2023 bond returns as more reflective of performance when starting yields are already elevated.
The current environment offers a unique opportunity for bond investors to capitalise on higher yields and lower volatility, making fixed income a compelling choice for de-risking portfolios.
Find out more about how to access today’s attractive opportunities in bonds here.
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