Is it time to return to bond funds?

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By Joseph Mossinternational banker

Jthere is no escaping the grim reality that bond markets have had one of their worst years on record. Typically, when global equity markets suffer as they did in 2022, investors increase their exposure to supposedly safer fixed income products, such as US government bonds. But steadily rising inflation expectations and soaring interest rates boosted yields and depressed prices in bond markets.

In general, bond funds have provided investors with protection during periods of market turbulence. But with uncharacteristically rising inflation in the United States, European Union and much of the rest of the world – and rapidly rising interest rates to contain that price spike – bonds have had an unequivocal year. awful so far. While consumer prices in many countries are rising at the fastest annual rate in more than 40 years, monetary tightening has accelerated. In the United States, which is the world’s largest bond market, the Federal Reserve (the Fed) was forced to raise interest rates by 0.75% in its last two rate-setting meetings for the first times since 1994.

BloombergThe popular US Aggregate Bond Index (the Agg), which tracks the investment grade bond market and is often the underlying index for bond funds, lost more than 10% in the first half of the year, while an ICE Bank of America index, which has tracked 7- to 10-year bonds since 1973, found that US Treasuries had lost 11% over the same six-month period. Thus, the bond market is on track this year to achieve its worst performance ever recorded. Indeed, it’s the worst first-half performance since 1788, Deutsche Bank recently noted, citing an index from Global Financial Data, which uses proxies for 10-year Treasury bills to compile centuries of bond yields. . Indeed, while a double-digit correction in equity markets is more common, it is virtually unheard of in the bond market.

By mid-June, the yield on the benchmark 10-year US Treasury had fallen to just under 3.5%, more than double the 1.51% recorded at the end of 2021, although it has since fallen below 2.8%. Nevertheless, this rally severely depressed bond prices. And in emerging markets, bond fund outflows of some $50 billion were recorded for the year to early July, with data from JPMorgan Chase showing those outflows were the worst emerging market bond funds have had. known in 17 years, as interest rates rose in advanced economies and the war in Ukraine triggered a mass exodus from emerging markets. “It’s been quite dramatic,” said Marco Ruijer, emerging markets portfolio manager at William Blair. FinancialTimesadding that soaring global inflation, rising interest rates and the war in Ukraine have combined to create “a perfect storm” for emerging market debt.

With inflation expectations remaining high for the foreseeable future, bond markets could continue to underperform for the rest of 2022. That said, economic growth is starting to slow in the United States and the broader global economy. After the Fed’s 75 basis point hike at the end of July, further hikes may not be as dramatic. Indeed, the fed funds futures market forecasts a peak rate of 3.3% in early 2023, before rate cuts are implemented later in the year. And with central banks around the world continuing to raise rates to bring down inflation, the substantial drop in excess cash circulating in the global economy and the slowing rate of global growth will likely cause yields to fall. long term, according to Charles Schwab Asset Management. last “Bond Market Update” published on August 3.

Much will ultimately depend on exactly when inflation peaks and begins to reverse. For some, prices can only fall after the 9.1% annual rise in U.S. consumer prices recorded in June, the highest since November 1981. “The June report will almost certainly mark the peak of the inflation as food and energy prices are set to fall sharply in next month’s report,” Morningstar chief U.S. economist Preston Caldwell said in mid-July. “The rise in inflation was strongly fueled by food and energy prices, but food and energy price indicators fell in July, which will appear in the next report on inflation. ‘CPI.’ Caldwell added that while the bulk of the inflation problem since the start of the pandemic has been caused by supply disruptions in automobiles, energy and food, he expects those problems to be resolved, “contributing to a slowdown in the inflationary surge”.

While inflation expectations may be starting to ease, fixed income assets may well rebound strongly. “Given the current tumultuous global environment, protecting portfolios with high-quality assets remains crucial,” noted Quentin Fitzsimmons, senior fixed income portfolio manager at investment management firm T. Rowe Price, in May. “There is also the threat that Europe’s energy supply will be cut off more drastically than currently expected, which would push Germany – and Europe – into recession. If recession risks increase significantly, expect downward pressure on yields as investors rush to protect portfolios.

The good news for investors is that the week ending August 3 saw high-quality US bond funds register their first inflows since March. Gains in this sub-sector have recently sparked an issuance frenzy, with companies such as Intel and Moody’s apparently entering the market. According to data from financial services firm Refinitiv Lipper, investors bought $1.22 billion net worth of investment-grade corporate bonds in the week ending Aug. a record 18-week streak of net outflows equating to $74 billion in total. “We found a very nice pocket of sustained market stability in investment grade for the first time in months,” Maureen O’Connor, global head of investment grade syndicate at Wells Fargo & Co., explained.

U.S. high-yield bonds are also gaining popularity, with mutual funds and exchange-traded funds (ETFs) seeing net positive demand of $2.93 billion in the same week, the second consecutive week of entries. Bond yields in the sector rose 5.9% in July, their biggest monthly rise in about a decade. But US leveraged loan funds continued to see net outflows, selling $344 million in the week to Aug. 3, marking the eighth straight week of outflows.

“Now is the time to reallocate money into fixed income,” said Lawrence Gillum, fixed income strategist at LPL Financial. Kiplinger early August, adding that currently higher yields will allow bonds to once again fulfill their role as an effective equity cushion and portfolio diversifier. That said, it would apparently reward investors for temporarily stepping back into the asset class rather than going all-in at this point. Indeed, Michael Fredericks, manager of the BlackRock Multi-Asset Income Fund, would advise investors not to invest in bonds “with all your chips” just yet. While Elaine Stokes, executive vice president and portfolio manager at investment firm Loomis Sayles, cautioned: “I wouldn’t go all out. I would start walking on tiptoe.

“Consider investing now,” Charles Schwab recently advised. “Treasury yields of all maturities rose, factoring in a peak federal funds rate near 3.3%.” But how exactly should one “consider investing now”? One of the most convenient and effective ways for an investor to gain broad exposure to the bond market is through bond funds. Similar to equity mutual funds or exchange-traded funds (ETFs), bond funds allow investors to pool their funds to gain exposure to different bonds from a variety of issuers, including corporations, governments and government agencies.

As bonds can be issued with various key parameters including yields, maturities, currencies and fixed/variable repayment terms, the bond universe consists of thousands of different debt products that will work in different ways. Rather than simply choosing a single bond that may carry more risk, a bond fund can gain broader exposure to this diversity of bonds in the most appropriate ratio that fund managers deem appropriate. Or they can target specific sections of that universe, like high-yield corporate bond funds or long-term Treasury funds. Indeed, higher yields can be found in short-term bond funds today; moreover, they are less sensitive to future changes in interest rates. “If you’re looking for yields of 3% to 3.5%, short-term Treasuries have become much more attractive,” Loomis Sayles’ Stokes explained to Kiplinger.

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