The strategic case for rebalancing into bonds

With bond yields reaching levels not seen in over a decade, investors are renewing their interest in fixed income. Guillermo Felices, PGIM Fixed Income’s global investment strategist, emphasises the strengthening strategic case for fixed income asset allocations.

He notes that from current elevated yield levels "bonds have historically delivered much better returns down the line”, and cautions against the perceived safety of cash investments, which can underperform when central banks cut rates.

In an interview with Asia Asset Management (AAM), Felices also highlights the defensive role of bonds, stating they can act as "great shock absorbers”, especially when central banks are either on hold or cutting rates.

When stocks fall, bonds have been a better shock absorber than cash

Robert Tipp, the company’s chief investment strategist and head of global bonds, concurs. Referencing his December 2022 paper¹, he tells AAM that the post-Covid market recovery has "turned back the clock 20 years, pushing yields back up to 2002 levels and setting bonds up for solid returns in the years ahead”.

Tipp also cites a November 2023 paper by Katherine Neiss and Ritush Dalmia², which highlighted the shift post Covid to a more erratic economic environment. He warns of a move towards a "more volatile, more inflationary environment" across both developed and emerging markets. “The silver lining”, he says, is “the return of higher yields, and the prospects for positive inflation adjusted returns”. He adds that over the long run "the higher yields will ultimately bring a steady state-run rate of higher bond returns”. 

A recent paper by Tipp, Felices, and George Jiranek, published in May this year³ advocates for rebalancing into bonds, particularly in the wake of recent strong equity gains. As Felices points out, "when equities are no longer cheap to bonds, bond returns, especially risk-adjusted returns, are historically a lot more attractive." He warns that the inverted yield curve’s apparent cash cushion may prove illusory given prospects for interest rate cuts. In short, this makes bonds a better long-term option.

Bonds Screen Cheap to Equities, Supporting Risk-Adjusted Performance

Tipp adds that "long term fixed income has fairly consistently outperformed cash over time”. Combined with the breadth of active management opportunities in the longer-term credit markets, this presents a compelling case for fixed income allocations, particularly at this point in the economic cycle.

As a result, particularly given current relative valuations, Tipp advises revisiting equity allocations, warning that their volatility can lead to significant value loss during downturns, making bonds a more stable alternative. He concludes that "fixed income is a major legitimate food group in the investment diet once again”, urging investors to consider rebalancing towards bonds for strategic stability. 

On the potential for value added via active management he emphasises that bonds are well-positioned to perform as a defensive asset class, particularly given current yields, a stable Federal Reserve, and potential geopolitical shocks.

Felices adds that fixed income offers multiple dimensions for active managers to leverage, including duration, regional exposure, dispersion within credit sectors, and risk levels.

While credit spreads are towards the narrow end of their historical ranges Tipp asserts that many credit sectors are now better positioned for a recession, even though one does not seem imminent.

Inflation bounce a problem for bonds?

Tipp acknowledges that recent disappointing inflation numbers and the pace of upcoming rate cuts remain topics of active debate but adds that he does not think a slower return to target inflation will prove to be a major problem.

However, he does warn that it could contribute to volatility. He adds that bond yields don't need to decline for bonds to perform well, as high yields can still lead to respectable returns if they remain within their range.

Comparing different markets, he also notes that the varied pace of post-Covid disinflation across countries is creating cross-market term structure plays, with some countries like Switzerland and those in the Eurozone having already begun cutting just as doubts around rate cut timing in the US and some other developed market countries swirl.

Regarding Japan, Tipp downplays concerns about interest rate normalisation causing Japanese investors to withdraw from foreign markets. He says that after the multi-hundred basis point post-Covid rate hike cycles elsewhere, “it seems premature to assume that the bear market in Japanese government bonds is over”, and that investors will rush to buy Japanese bonds; “Those concerns seem overblown," he adds.

Commenting on the upcoming elections, he says any changes in the trend of loose fiscal policy in the US seem unlikely, with successes in tax cuts and increased spending under Trump and Biden, respectively. He also highlights the significant US deficit and mentions that tariffs and friendshoring might maintain some inflationary pressures while potentially boosting US growth.

Felices agrees, suggesting continued fiscal activism may be driving demand. However, he warns of potential supply constraints or shocks, including climate-related disruptions. He predicts that the Labour Party is likely to come to power in the UK, with an initial focus on fiscal responsibility and increasing productivity through ambitious reforms and a closer relationship with the European Union.

Portfolio construction

Tipp notes that in PGIM's portfolios, he sees the best opportunities for adding value on the credit side. He says that "although credit spreads have already tightened significantly, we continue to see opportunities in spread products over the intermediate term”.

He also highlights active rebalancing across investment grade and high yield and investment grade corporates, structured products and emerging market areas, which can create value-adding opportunities. He anticipates the credit sectors to deliver on balance "positive excess returns on average over the long term”.

Felices adds that the areas that look most attractive are “some shorter-term high yield spread products and some structured products as well”. He explains that higher yields have broadened the opportunity set, making these areas particularly interesting from a risk-reward perspective.

Insights for Asian investors

Tipp offers specific insights for Asian investors, emphasising the capital-rich nature of the region. He notes that “local securities tend to be, all else equal, more fully valued than those abroad, given that many foreign markets are net borrowers, whereas Asia is comparatively awash in capital”.

He finds that international fixed income, particularly when hedged, tends to offer more attractive risk-adjusted returns than Asian fixed income due to this capital imbalance and suggests that "there are good opportunities for Asian investors to invest globally on a hedged basis”. This, he says, will allow Asian investors to capitalise on this valuation differential, and may enhance their portfolio’s risk adjusted returns by leveraging the higher risk premiums available in foreign markets.

¹ https://www.pgim.com/fixed-income/blog/yield-destiny-bonds-are-back
² https://www.pgim.com/fixed-income/white-paper/nice-vile-future-inflation
³ https://www.pgim.com/fixed-income/blog/case-rebalancing-bonds-pictures

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