Will fixed income be the shining light of 2024?

There are plenty of reasons to look at fixed income anew for 2024. The income available is far higher than it has been in recent years, and an environment of falling interest rates and inflation should be a supportive one. However, there are some potential pitfalls, such as high government debt and geopolitical uncertainty, that could destabilise parts of the bond market. In theory, strategic bond fund managers should be in a good position to navigate this environment.

Why strategic bonds?

Strategic bond fund managers have all the fixed income tools at their fingertips: government and corporate bonds, high yield and investment grade, emerging markets and developed markets. They can be flexible on duration, on currency, on credit risk or on inflation-protection. While most funds do not have the resources to explore every option, it means that strategic bond managers can adapt to different market conditions.

How did strategic bond funds perform in 2023?

This was seen in 2023. While the average fund in the sector delivered a return of 7.8%*, there were very different outcomes depending on the investment positioning of the fund. At the top, Man GLG Dynamic Income stood out with a 24.9% return, more than 11% ahead of its nearest rival, the M&G Optimal Income fund, managed by Richard Woolnough, which returned 13.5%*.

Among the other Elite Rated funds, TwentyFour Dynamic Bond also outpaced the sector average, with a return of 9.6%, while Aegon Strategic Bond, Baillie Gifford Strategic Bond and Jupiter Strategic Bond delivered 9.1%, 9.1% and 8.9% respectively*.

In hindsight, the opportunity was to take greater risk within the asset class – as managers that recognised the value inherent in corporate bonds, and particularly in high yield, fared well. The Investment Association Sterling High Yield, Corporate Bonds, Strategic Bonds and Global Emerging Market Bonds were the top four performing sectors in 2023.

After a brief spike in March, corporate bond spreads narrowed throughout the year and by December were at their lowest point in almost two years. For clarity, the yield on a corporate bond fund is made up of two parts – the risk-free rate (i.e. gilts) and the spread (the difference in yield between the corporate bond yield and the risk-free rate you can get on government bonds).

Developed market government bonds, in contrast, had a tougher year. Yields remained in a relatively narrow range for the first half of the year, spiking significantly higher from August onwards as markets started to price in a ‘higher for longer’ scenario for interest rates. Ultimately, once there was a recognition that we had reached a peak for interest rates, yields did start to drop again and we saw a rally in the likes of UK Gilts – which ended the year up 4%, having been down 5% in mid-October 2023. Nevertheless, it was a difficult year for managers that had taken a bearish position on economic growth, and assumed that inflation and therefore interest rates would fall harder and faster than they did.

What’s in store for the year ahead?

The environment facing investors at the start of 2024 appears very different.

Inflation has more than halved, yet growth has remained resilient. This is particularly true in the US, where the jobs market and consumer confidence has continued to power the economy forward. The long-awaited recession has yet to materialise, but the Federal Reserve is forecasting rate cuts in the year ahead. Inflation continues to drop, although this unlikely to be in a straight line from here.

This should be a benign environment for government bonds, particularly at the longer-duration end where there is more sensitivity to rate cuts. There are caveats, however: a revival in inflation is still plausible, and the level of debt held by developed market governments is still a risk if buyers start to question their credit-worthiness.

However, it is difficult to see corporate bonds repeating their 2023 success. Spreads over government bonds are low, and leave little margin for error should the economic outcome be worse than is currently expected. Managers are treading carefully, and are generally avoiding the higher-risk end of corporate credit spectrum, where distress is likely to be felt more acutely.

What do our Elite Rated managers have to say?

Within those broad parameters, strategic bond managers reflect a significant breadth of views. In its latest fixed income update, M&G says: “Inflation is definitely moving into the right direction as money supply has been constrained. However, there is a possibility that things might not move as fast as people are starting to expect. We believe it is important to enjoy the rally for now, but patience is necessary. The more good news is priced in by the market, the lower expected returns become, while chances for negative surprises increase.”

On the M&G Optimal Income fund, Richard Woolnough has shifted his positioning from being short duration and long credit to being long duration and broadly neutral on credit, adding: “While credit valuations still remain historically reasonable, the margin for error is diminishing; in our view, investors should become more selective in this environment and avoid taking excessive risk.”

There are others who take a far more pessimistic view on the economic outcome in the year ahead. Mike Riddell, manager of the Allianz Strategic Bond fund, had a tough year in 2023, where the fund fell 3.6%*. Investors who have backed him over the longer term will be used to these fluctuations. He takes bold positions in the fund that will often see him diverge significantly from the wider sector.

Over the past two years, the fund has been positioned for a recession and weaker inflation, which has not yet materialised. Nevertheless, Mike is sticking to his view that, “all the hikes through 2022 and the beginning of 2023 would cause weaker growth and recessions/crises, and the market would start pricing in rate cuts over the next few years rather than lots of rate hikes.” He says the fund should act as a good diversifier alongside risk assets such as equities or higher yielding corporate bonds.

Ariel Bezalel, manager of the Jupiter Strategic Bond fund, sits somewhere between the two. He believes the lag effect of rising rates will continue to weigh on economic growth, while tighter lending standards will also reduce activity. Consumption will weaken as pandemic savings are depleted.

He adds: “Outside the US, the environment looks even more fragile. Higher reliance on manufacturing has already brought the Eurozone into, what de facto is, a mild recession. Similar trends are also appearing in the UK, where mortgage repricing remains a key risk. Finally, we still believe that China will continue to disappoint as it wrestles with many structural issues for years to come. These developments will provide central banks across the globe with reasons (or perhaps the need) to be less hawkish.”

Ariel sees value in some government bonds in developed markets, alongside emerging markets such as South Korea and Brazil. In corporate credit, the fund has a higher weighting in more defensive sectors such as telecommunications, healthcare, consumer staples and selectively across financials, while avoiding more cyclical sectors, where it sees some complacency in valuations and potential weakness ahead.

The fixed income market looks very different at the start of 2024 and managers are adjusting their positioning for this new reality. There are options for investors in the strategic bond sector across the spectrum of optimistic to pessimistic, but strategic bond funds can be an important way to navigate the complexities of fixed income markets in the year ahead.

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*Source: FE Analytics, total returns in sterling, 2 January 2023 to 29 December 2023