It’s been a tough year for bond investors so far. As inflation picked up, monetary authorities worldwide signaled their intent to hike rates. That pushed market yields for bonds higher and prices lower. And with the latest annual consumer price data in the US and in the Euro Area running at 8.5% and 7.5, respectively, bond investors could understandably, be concerned that there’s still more poor returns to come.

As painful as it was, the selloff has creating opportunities for investors. The steep rise in yields should mean that income investors are now finally able to earn relatively attractive yields in the bond market after enduring nearly three years of near-zero interest rates. While it may seem counterintuitive to buy bonds as major central banks embark on a policy tightening path, there is reason to believe that much of the bad news is already discounted. As such, the risk/reward in certain segments of the bond market has improved significantly.

The policy stance of the major central banks has changed a lot in the past few months. Until December, most monetary authorities were focused on the potential negative economic fallout from the pandemic and were cautious about exiting the easy monetary policy stance that proved instrumental in Covid times. The stronger than expected recovery, along with the spike in commodity prices due to Russia’s invasion of Ukraine, forced the Fed and other central banks to shift toward tighter policy. Consequently, yields jumped across the curve, led by a steep rise in short-term rates.

In the US , the market is now discounting a fast pace of Fed rate hikes, with the federal funds rate expected to reach as high as 3% in early 2023. Considering that the Fed has only raised rates once, a lot of future rate hikes are already being discounted by the market. As a consequence, yields are now converging between two-year and 10-year maturities. They are currently hovering around the Fed’s longer run estimate of the “neutral rate” of about 2.5% – the rate that is low enough to support economic growth but high enough to keep inflation in check. In past cycles, when the yield curve flattened near the neutral rate, it has been near the peak in long-term rates.

The biggest concern for fixed income investors remains the very high inflation numbers. Although it is likely to remain high in the near term due to rising commodity prices, it is expected to ease later in the year – providing some relief for bond investors. In fact, the global economy is starting to show signs of cooling off after a sharp rebound from pandemic lows. It appears that a lot of consumption was likely pulled forward by the combination of easy fiscal and monetary polices last year. Now the pace is moderating, especially in key areas where the cost of financing is rising.

Inflation is a policy choice, and the major central banks (with a few exceptions like Japan and China) are choosing to bring it down. Even Europe, where the war in Ukraine is already having a negative impact on growth, tighter monetary policy is in the works. In the US, the Fed has clearly signaled it wants inflation to come down and although it cannot do much about the supply side shocks lifting inflation, it can depress inflation. In fact, by raising the cost of money and reducing reserves in the banking system, the Fed can slow growth. That probably means higher unemployment on the horizon as slower consumer spending and capital investment mean fewer jobs. Since inflation is a lagging indicator, the impact of the tightening now is likely to show up in the next six to 12 months.

While bond investors may have taken some pain this year, that doesn’t mean it’s time to run from the asset class. The risk/reward for bonds has improved now that yields have jumped up and the signs from the yield curve suggest the peak in yields for the cycle may be getting closer. It may be a bumpy ride, but current yields in many areas of the market are high enough to make taking more duration and/or credit risk worthwhile. Nonetheless, as the cycle of tightening global liquidity plays out, investors should be more cautious towards riskier segments of the market, like high yield. Central banks are trying to tighten financial conditions to reduce inflation and that is often associated with greater volatility in lower credit quality and less liquid markets.

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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