The case for a career in bond investing

Back from de. Last week, I was tasked with convincing a class of brilliant young MBA students at one of Europe’s leing business schools that y should consider a career in bond investing. It was not an easy sell.
Bonds, I explained, tritionally serve three purposes. First, y deliver a positive income. That prompted polite guffaws. I should not have been surprised. In 2022, aggregate U.S. market for fixed income securities notched up its worst annual performance since 1871, and U.S. Treasury bonds are currently on track for three consecutive calendar years of negative returns – something that has never happened before.

Bonds contribute capital stability, I parried, in contrast to flighty equities. More sniggers at back. I sensed familiarity with recent fate of fixed income benchmarks such as Austria’s hundred-year government bond. That security, which was issued in 2017, is down around 75% from its peak valuation in late 2020.

re was still fixed income’s trump card. Its third tritional function is as ballast: an asset class whose negative correlation with equities can diversify a portfolio and reduce overall risk without giving up returns. n I remembered that in 2022 equities and bonds dropped in tandem, resulting in worst performance for classic 60:40 balanced portfolio since 1974.

private equity session was about to start down hall. Some of more ambitious students were beginning to slink towards door. It was time for a change of tack.

It is true, I mitted, that being a bond investor has been tough for much of past 15 years and positively traumatic over past two. But you should not choose your future career by looking in rear-view mirror. three fundamental drivers of fixed income returns that distinguish m from equities imply that immediate future is likely to be very different from past.

first is interest-rate risk. That has certainly been a handicap for investors over past two years as rising yields battered market value of long bond positions.

Yet result is that yields today are at far more attractive levels. yield on nominal 10-year U.S. Treasury notes touched 5% this week, while ir inflation-protected cousins are yielding 2.5%. This means even plainest vanilla assets in global system provide income sufficient to fund medium-term liabilities again.

That’s a welcome change on its own, but it comes with an even more important kicker. income and capital payments on bonds are contractually fixed, unlike cash flows provided by equities. For this reason, when bond yields are low, sensitivity of capital prices to inflation and interest rate shocks is high, and vice versa. This critical property of fixed income securities – “convexity” in jargon – means that as bonds sell off, ir downside risk mechanically falls. That is quite a contrast to dynamics affecting equity values.

Precisely because of carnage of past two years, cushion of convexity alrey makes a material difference to risk-reward ratio in global government bonds. And if current expectations for growth, inflation and policy interest rates turn out to be too bullish, its effect will swing into reverse: falling yields will deliver capital gains from rising bond prices at an accelerating pace. Don’t let anyone tell you that bond maths can’t be fun.

second potential source of return in fixed income is credit – reward for bearing risk that bond issuer defaults. picture here is mittedly less clear-cut. While underlying government yield curves have justed materially, many credit spres have moved much less.

Neverless Torsten Slok, chief economist at Apollo Global Management, points out that upward shift in U.S. Treasury curve alone means that yield on BBB-rated U.S. corporate bonds is now two and a half percentage points higher than earnings yield of S&P 500. Since latter metric measures totality of profits available for distribution to shareholders, that suggests bonds issued by investment-gre U.S. companies are now better value than ir equities, after more than a dece in ir show.

In more esoteric parts of global credit universe, valuations now look healthy in absolute terms as well. U.S. dollar-denominated bonds of emerging-market governments are a case in point. yield of benchmark JPMorgan EMBI-GD index is close to 4.5% above U.S. Treasuries. But fund manager GMO’s emerging debt team calculates that recent ratings upgres imply expected credit losses of only one third of that differential. If historical averages prove a reliable guide, that suggests an annualised return for emerging-market sovereign debt of nearly 5% over U.S. Treasuries over coming two years.

For those brave enough to make event-driven bets on today’s chaotic geopolitical environment, potentially greater opportunities await. Look no furr than Venezuela for proof. After U.S. eased sanctions last week, its dollar-denominated bonds nearly doubled in price.

Finally, re is third engine of returns for global fixed income investors: currency risk. No one would pretend this is a game for faint-hearted – or that valuation alone is a sure-fire route to success. Yet it is hard to ignore that of 54 global currencies monitored by Economist for its Big Mac index, all but seven are currently cheap when compared to U.S. dollar. appreciating greenback has been a drag on much of global fixed income universe for past dece. Positioning for a reversal could be tre of next one.

My tire h stemmed outflow of students. It was time to go in for kill. real reason to go into fixed income investing, I explained, is that you get to tell governments what to do. rapid fall of UK Prime Minister Liz Truss just over a year ago showed “bond vigilantes” are back.

It has been three deces since U.S. President Bill Clinton’s campaign supremo, James Carville, said he’d like to be reincarnated as bond market, because n he could intimidate everybody. Now that end of monetary anaessia has awoken fixed income from its 15-year coma, I told MBA students, you’ve got your chance.