Bets on bond renaissance frustrated by stubbornly high inflation

Investors have piled into fixed income this year, lured by the promise that bonds were back after a year of miserable returns. So far, that trade has failed to deliver bumper returns.

Global bond markets have lost 1 per cent this quarter, as stubbornly high inflation on both sides of the Atlantic pushes big central banks to keep raising interest rates. Following a 3 per cent gain in the first quarter, that setback means the asset class so far has not delivered on its promise of a strong rebound after last year’s historic 16 per cent loss for the Bloomberg Global Aggregate index — a broad gauge of global fixed income and the benchmark for many bond funds.

Investors betting that inflation is on its way down as recession looms are “up to their eyeballs” in bonds, said Jim Bianco, president of Bianco Research. “It has been a painful bet. Over the last five or six weeks, there have been a number of them seeing their performance getting hurt,” he added.

Investors loaded up on bonds at the start of the year, with nearly $113bn flowing into taxable bond funds in the first five months of 2023, according to Morningstar data, a marked difference from the $107bn of outflows last year over the same period.

The flood of cash came as big money managers including JPMorgan, Pimco, Charles Schwab, Fidelity Investments, and Amundi declared that “bonds are back”.

Buyers were looking to capture the highest yields available in years. But many were also betting that the cycle of interest rate increases from the US Federal Reserve and other central banks — which was behind 2022’s fixed income bloodbath — was nearly at an end.

Earlier this spring, investors in the futures market were betting that the Fed would be forced to cut interest rates multiple times this year. But at June’s Fed meeting, the committee released its latest “dot plot” which showed that officials expected interest rates to rise to 5.6 per cent this year, implying an additional two interest rate increases.

The European Central Bank similarly warned of further rises in borrowing costs at its June meeting, while the Bank of England this week surprised markets with a bigger than expected half percentage point rate increase.

Those moves have been bad news for investors who bought short-dated government debt — which is highly sensitive to the outlook for interest rates — on expectations that the peak in borrowing costs was near.

The two-year Treasury yield on Friday rose to its highest level in three months after Fed chair Jay Powell said in testimony before the US Congress that the central bank’s fight against inflation was not over.

“If you piled into short duration rates at the beginning of the year, you are probably feeling some pain, because rates have continued to move higher,” said Jason England, the global bonds portfolio manager at Janus Henderson.

The iShares exchange traded fund which tracks the 1-3 year segment of the US Treasury market has lost 0.6 per cent so far in June, and lost 0.6 per cent in May too.

Although the declines look modest compared with last year’s sell-off, some of the enthusiasm for fixed income appears to be waning.

There have been outflows worth $763mn out of short-dated government bond funds in April and May, according to Morningstar data. Inflows into the broad taxable bond fund category have slowed slightly — $71bn came in during the first quarter, with only $42bn in April and May.

“We wouldn’t need to be coming out with slogans like ‘bonds are back’ if the money was coming in organically,” said a senior analyst at an asset manager.

Some of those outflows may be attributable to the fact that Treasury bills — the ultra-short, ultra-safe US bonds that mature in anywhere from a few days to a year — are offering the best returns in decades, well above those available on longer-duration bonds that carry more risk.

“What we’re hearing anecdotally is investors are content to sit in Treasury bills and government money market funds, and just clip that yield there, as opposed to short-dated fixed income,” said Alex Obaza, a portfolio manager at T Rowe Price. “We’ve seen some outflows from short-term bonds funds.”

Despite the lacklustre performance, many fund managers remain relaxed about their bets on fixed income, arguing that the higher yields offer a margin for error, meaning holders can still make a positive return even if prices fall modestly.

The cushion afforded by chunkier yields was “the story of bonds ultimately”, said Greg Peters, co-chief investment officer at PGIM Fixed Income.

“When rates were at zero or negative, and spreads were tight, that was the worst environment because there was no cushion. So I feel much, much more comfortable owning bonds today than I did in 2017,” he said.