It feels a bit like déjà vu. Here we are, a quarter of the way through a year which has been heralded as the year for bonds, and so far the broad performance of fixed income has been rather lacklustre. However, we think key macroeconomic and market signals are pointing to a supportive environment for bonds and there are compelling opportunities for investors looking for income and diversification.

Finding the bond opportunities

In our Global Aggregate Bond Fund, we have focused on exploiting the current income opportunity by capturing a yield higher than the market. The current macro environment has led us to own a diversified basket of high quality spread sectors, such as investment grade (IG) credit and agency mortgage backed securities.

Although credit spreads are relatively tight, the corporate bond market is currently a source of attractive income. Our view on this area of the market is grounded in the solid fundamental backdrop: forecasts for earnings growth is positive for the year ahead and there is evidence of stabilising net and gross leverage levels.

Within the corporate sector, we have a preference for investment grade corporates over high yield, as valuations are slightly cheaper in the IG space compared to history. The area in IG that we find as the most attractive is the banking sector, where the subordinate parts of banks’ capital structures are trading particularly cheaply.

We also like the fundamentals and market valuations on offer for agency mortgages. The segment currently offers a healthy amount of income, and with interest rate volatility likely to decline going forward, there is scope for yields to compress. The technical backdrop is supportive as well, with banks likely to re-enter the market after a period of interest rate volatility.

In regards to duration, we think government bonds will trade within a range in the near term and we therefore have more conviction in relative value between countries. Specifically, we prefer positioning underweight US vs. overweight Europe, which reflects our views on the relative growth outlooks of the two regions.

Fixed income during an easing cycle

So what's influencing our positions and thinking? One of the key factors is the economic backdrop. It may be taking longer than the market initially expected, but interest rate cuts are most likely on the way in developed markets. Central bankers have indicated that current monetary conditions are sufficiently restrictive and, despite some resilient economic data, some loosening will be necessary to facilitate the soft landing that they so keenly desire.

In our latest investment quarterly meeting, we increased our probability of sub trend growth to 70%. Although recent hotter than expected inflation has surprised markets, we ultimately think inflation will continue falling closer to central bank targets by the end of the year.

Investors who rotated into cash were one of the beneficiaries of the high interest rates we’ve seen over the last couple of years, achieving returns ahead of significantly riskier assets. But now, with interest rates cuts seemingly on the horizon, those same returns are unlikely to be replicated, and other assets have caught up.

Historically, bonds have a good track record of outperforming cash once peak interest rates have been reached. It does appear that we are currently at peak interest rates, so we think the current environment could provide an attractive backdrop for fixed income.

Bonds have got their mojo back

Bonds are regaining the key elements that investors tend to look for when investing in the asset class: income and diversification. On the former, real yields on global government bonds are now firmly back in positive territory and close to their 100 year average, having languished close to 0% or negative for the best part of a decade.

Most of this move can be attributed to a significant repricing in bonds, but part of it is down to inflation receding from the excessive levels we saw in 2022. This decline in inflation also bodes well for the diversification element of fixed income.

Generally, bonds and equities are meant to move in opposite directions but in periods of high inflation, this relationship is reversed and the two asset classes move in tandem. This has certainly been the case over the last two years, but with inflation declining towards more normal levels, we expect to see the natural inverse relationship resume. Given current real yield levels, we think bonds have room to rally and prove themselves as the reliable risk hedge that investors seek.

Conclusion

Overall, we think the picture looks quite appealing for fixed income markets. Central banks are poised to cut interest rates, fixed income valuations are attractive, and bonds are once again offering income and diversification. We think a strategy with the research capabilities to exploit these opportunities could be an enticing prospect for investors looking to step up from cash.