Bullish on bonds in 2023
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Bullish on bonds in 2023

The next 12 months are poised to be a comeback year for fixed income, says Gene Tannuzzo, with a focus on quality and credit selection critical to achieving the desired outcomes.

Global bond markets were rattled in 2022 by the aggressive policy pivot of major central banks to address persistent inflation. In the US and abroad returns have been historically and pitifully poor. Throughout the year volatility – primarily emanating from rising interest rates – saw those bonds most sensitive to changes in interest rates, such as government bonds, generate deeply negative returns. But lower quality bonds – those rated below investment grade – also woefully underperformed. This is why fixed income investors could have lost just as much money in treasuries as they did in high yield bonds (Figure 1).
Figure 1: 2022 has been a tough year across fixed income (rolling 12-month total return, %)
ar across fixed income (rolling 12-month total return, %)
Source: Bloomberg LP As at 15 October 2022. Government bonds are represented by the Bloomberg US Treasury Index, which measures US dollar-denominated, fixed rate, nominal debt issues by the US Treasury. High yield bonds are represented by the Bloomberg US Corporate High Yield Index, which measures the US dollar-denominated, high yield, fixed rate corporate bond market
There is nearly universal agreement on what it will take to stop the carnage: clarity on an end to central bank rate rises. US Federal Reserve chair, Jay Powell, has made it clear that the central bank wants to see “compelling evidence of inflation easing” before it shifts policy1.
But central banks are in a predicament. They know that monetary policy impacts the real economy with a lag. If we assume, for argument’s sake, that it takes six months for changes in interest rates to impact growth then, for example, the very first Fed rate hikes from early 2022 are just starting to bite in the US, with more pain to follow. This phenomenon of more pain is often referred to as “tighter financial conditions”. Simply stated, central banks are trying to drive economic growth lower and take the pressure off inflation by reducing demand through higher interest rates, which increases the cost of financing for consumers and corporations. Have they been successful? The “good” news is that the US is seeing evidence that its policy is starting to work. The risk is that they go too far with their interest rate hiking regime. Historically, financial conditions any tighter than what we have today have been associated with recessions.

A different driver of fixed income

Rate hikes and tighter financial conditions drove fixed income returns lower in 2022. Heading into 2023 we should see economies slow pretty dramatically. But I don’t think we will see a repeat of 2008 or 2020, in which the slowdown was extraordinarily deep in specific areas of the economy. Instead, because financial conditions have tightened so much, I think economic pain will hit the tail of every industry. This means that companies and consumers with too much leverage, and sovereigns that are not well positioned to deal with elevated levels of currency volatility, are going to come under increased pressure.

Investors no longer have the benefit of policy-based shock absorbers – like quantitative easing or artificially low rates – to protect their portfolios and will need to find new buffers to cushion the impact of market and economic volatility. This essentially means a higher credit quality: companies with strong fundamentals, a healthy cash flow and lower leverage. It can also involve pivoting away from certain risks, including securities that are overexposed to the low end of consumer credit, to owning asset classes like municipal bonds and agency mortgage-backed securities.

The broad repricing of bonds and the higher starting yields we now have can help insulate investors from further losses. The yield curve is very flat and very high, which means even if investors are not comfortable with longer duration bonds, there are attractive opportunities in short-term corporate bonds which are yielding around 5.5% or 6%2.
For those who are comfortable with longer duration bonds, pay attention to the duration narrative which, in the US I think, will shift from focusing on the aggressive Fed hiking cycle to the impact of the Fed pausing rate increases. We have previously seen negative returns in the bond market followed by high, if not double-digit, returns once policy changes course, but the market response to the end of the hiking cycle generally happens very quickly, and trying to time the bottom can mean an investor misses out.

Valuations are very attractive, but pay attention to risk

Investment grade bonds, which were down around 20% this year3, could provide better outcomes in 2023 because they represent companies that don’t necessarily need to refinance in what will be a less conducive environment. There has also been enough of a fundamental disconnect between Europe and the US that this is probably the first time in many years that opportunities in Europe appear more attractive relative to the US – particularly in investment grade bonds which have already priced in the geopolitical risk around Russia and Ukraine, and now you have a risk premium to compensate for that. High yield appears fully valued to us but could also stand to benefit if the economy can avoid a recession in the year ahead.

Optimism for 2023

I don’t think 2023 will be a repeat of 2022. This is not a time to stay on the sidelines. There are very compelling total return opportunities in high-quality assets. There are risks but investors are being well-compensated, and a focus on quality and credit selection will be critical to setting the stage of successful fixed income investment outcomes.
9 december 2022
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Bullish on bonds in 2023

1FT.com, Jay Powell faces test of Fed’s ‘unconditional’ resolve to tame inflation, 22 June 2022

2Bloomberg, as at November 2022

3Bloomberg, year to date as at November 2022

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The securities included herein are for illustrative purposes only, subject to change and should not be construed as a recommendation to buy or sell. Securities discussed may or may not prove profitable. The views expressed are as of the date given, may change as market or other conditions change and may differ from views expressed by other Columbia Threadneedle Investments (Columbia Threadneedle) associates or affiliates. Actual investments or investment decisions made by Columbia Threadneedle and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be appropriate for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either.

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In the Middle East: This document is distributed by Columbia Threadneedle Investments (ME) Limited, which is regulated by the Dubai Financial Services Authority (DFSA). For Distributors: This document is intended to provide distributors’ with information about Group products and services and is not for further distribution. For Institutional Clients: The information in this document is not intended as financial advice and is only intended for persons with appropriate investment knowledge and who meet the regulatory criteria to be classified as a Professional Client or Market Counterparties and no other Person should act upon it.

Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies.

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Important information

For use by professional clients and/or equivalent investor types in your jurisdiction (not to be used with or passed on to retail clients). This is an advertising document. This document is intended for informational purposes only and should not be considered representative of any particular investment. This should not be considered an offer or solicitation to buy or sell any securities or other financial instruments, or to provide investment advice or services.

Investing involves risk including the risk of loss of principal. Your capital is at risk. Market risk may affect a single issuer, sector of the economy, industry or the market as a whole. The value of investments is not guaranteed, and therefore an investor may not get back the amount invested. International investing involves certain risks and volatility due to potential political, economic or currency fluctuations and different financial and accounting standards. Risks are enhanced for emerging market issuers.

The securities included herein are for illustrative purposes only, subject to change and should not be construed as a recommendation to buy or sell. Securities discussed may or may not prove profitable. The views expressed are as of the date given, may change as market or other conditions change and may differ from views expressed by other Columbia Threadneedle Investments (Columbia Threadneedle) associates or affiliates. Actual investments or investment decisions made by Columbia Threadneedle and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be appropriate for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either.

Information and opinions provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. This is an advertising document. This document and its contents have not been reviewed by any regulatory authority.

In Australia: Issued by Threadneedle Investments Singapore (Pte.) Limited [“TIS”], ARBN 600 027 414. TIS is exempt from the requirement to hold an Australian financial services licence under the Corporations Act 2001 (Cth) and relies on Class Order 03/1102 in respect of the financial services it provides to wholesale clients in Australia. This document should only be distributed in Australia to “wholesale clients” as defined in Section 761G of the Corporations Act. TIS is regulated in Singapore (Registration number: 201101559W) by the Monetary Authority of Singapore under the Securities and Futures Act (Chapter 289), which differ from Australian laws.

In Singapore: Issued by Threadneedle Investments Singapore (Pte.) Limited, 3 Killiney Road, #07-07, Winsland House 1, Singapore 239519, which is regulated in Singapore by the Monetary Authority of Singapore under the Securities and Futures Act (Chapter 289). Registration number: 201101559W. This advertisement has not been reviewed by the Monetary Authority of Singapore.

In Hong Kong: Issued by Threadneedle Portfolio Services Hong Kong Limited 天利投資管理香港有限公司. Unit 3004, Two Exchange Square, 8 Connaught Place, Hong Kong, which is licensed by the Securities and Futures Commission (“SFC”) to conduct Type 1 regulated activities (CE:AQA779). Registered in Hong Kong under the Companies Ordinance (Chapter 622), No. 1173058.

In Japan: Issued by Columbia Threadneedle Investments Japan Co., Ltd. Financial Instruments Business Operator, The Director-General of Kanto Local Finance Bureau (FIBO) No.3281, and a member of Japan Investment Advisers Association and Type II Financial Instruments Firms Association.

In the USA: Investment products offered through Columbia Management Investment Distributors, Inc., member FINRA. Advisory services provided by Columbia Management Investment Advisers, LLC.

In the UK: Issued by Threadneedle Asset Management Limited. Registered in England and Wales, Registered No. 573204, Cannon Place, 78 Cannon Street, London EC4N 6AG, United Kingdom. Authorised and regulated in the UK by the Financial Conduct Authority.

In the EEA: Issued by Threadneedle Management Luxembourg S.A. Registered with the Registre de Commerce et des Societes (Luxembourg), Registered No. B 110242, 44, rue de la Vallée, L-2661 Luxembourg, Grand Duchy of Luxembourg.

In Switzerland: Issued by Threadneedle Portfolio Services AG, Registered address: Claridenstrasse 41, 8002 Zurich, Switzerland.

In the Middle East: This document is distributed by Columbia Threadneedle Investments (ME) Limited, which is regulated by the Dubai Financial Services Authority (DFSA). For Distributors: This document is intended to provide distributors’ with information about Group products and services and is not for further distribution. For Institutional Clients: The information in this document is not intended as financial advice and is only intended for persons with appropriate investment knowledge and who meet the regulatory criteria to be classified as a Professional Client or Market Counterparties and no other Person should act upon it.

Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies.

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