Bond Investing: A Challenging but Promising Career Path
Last week, at one of Europe’s top business schools, a group of MBA students were presented with the idea of pursuing a career in bond investing. However, it became evident that convincing these bright young minds of the potential in this field was no easy task.
Traditionally, bonds have served three purposes. Firstly, they provide a positive income. However, with the aggregate U.S. market for fixed-income securities experiencing its worst annual performance since 1871, and U.S. Treasury bonds predicted to record three consecutive years of negative returns for the first time ever, it’s understandable that the students were skeptical.
Secondly, bonds offer capital stability compared to the volatility of equities. Yet, recent events, such as the sharp decline in Austria’s hundred-year government bond, which lost around 75% of its peak value in 2020, have raised doubts about this perceived stability.
The third advantage of fixed income investments is their ability to act as a ballast, diversifying a portfolio and reducing overall risk without sacrificing returns. However, the combined poor performance of both equities and bonds in 2022 resulted in the worst returns for the classic 60:40 balanced portfolio since 1974.
As the private equity session loomed nearby, some of the bolder students began to lose interest. It was time for a change in approach.
Acknowledging the difficulties faced by bond investors in recent years, it was highlighted that basing career decisions solely on past performance is not prudent. Instead, it’s essential to consider the three fundamental drivers of fixed-income returns that differentiate them from equities, as they indicate a future that may be vastly different from the past.
The first driver is interest-rate risk, which has been a major obstacle for investors in recent years due to rising yields. However, this has led to more attractive yield levels. For instance, 10-year U.S. Treasury notes now offer a yield of 5%, while their inflation-protected counterparts yield 2.5%. This means even straightforward assets in the global system can now provide sufficient income to meet medium-term liabilities.
Additionally, fixed income securities have contractually fixed income and capital payments, unlike equities. This property, known as “convexity,” creates a negative correlation between bond prices and inflation and interest rate shocks. Therefore, as bond prices fall, their downside risk decreases, which is in stark contrast to the dynamics affecting equity values.
The carnage experienced in the past two years has already made a noticeable impact on the risk-reward ratio in global government bonds, thanks to the cushion provided by convexity. If growth, inflation, and policy interest rates fail to meet current expectations, falling yields will result in capital gains from rising bond prices. This aspect of bond investing’s mathematics can indeed be enjoyable.
The second potential source of returns in fixed income is credit, which compensates investors for the risk of default by bond issuers. The situation here is not as clear-cut, as credit spreads have not adjusted significantly despite significant changes in underlying government yield curves. However, compared to the earnings yield of the S&P 500, the yield on BBB-rated U.S. corporate bonds now stands two and a half percentage points higher. This suggests that investment-grade U.S. corporate bonds offer better value than equities after being overshadowed for over a decade.
In more niche areas of the global credit market, valuations appear healthy in absolute terms. For instance, U.S. dollar-denominated bonds issued by emerging-market governments offer attractive yields compared to U.S. Treasuries. Recent ratings upgrades imply expected credit losses that are only one third of the yield differential. Based on historical averages, this suggests an annualized return of nearly 5% over U.S. Treasuries for emerging market sovereign debt over the next two years.
For those willing to take on the risks of event-driven bets in today’s chaotic geopolitical landscape, even greater opportunities await. The recent doubling in price of Venezuela’s dollar-denominated bonds after the U.S. eased sanctions serves as proof.
Lastly, currency risk presents the third engine of returns for global fixed-income investors. Although it is not for the faint-hearted, the current valuation of global currencies when compared to the U.S. dollar is difficult to ignore. All but seven of 54 global currencies monitored by the Economist’s Big Mac index are currently undervalued against the dollar. The appreciating value of the dollar has been a drag on the global fixed income market for the past decade, but positioning for a reversal could be a lucrative trade in the future.
To conclude the presentation, the students were reminded that investing in fixed income provides an opportunity to influence governments. The fall of UK Prime Minister Liz Truss a year ago demonstrated the power of the “bond vigilantes.”
After 15 years of a dormant market due to monetary policies, the awakening of fixed income offers a chance for these MBA students to make their mark. As James Carville once famously said, “I’d like to be reincarnated as the
More detail via Reuters here… ( Image via Reuters )