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Authored by: Ben Bennett, Chief Investment Strategist, Asia, L&G – Asset Management

The global economy faces headwinds from elevated oil prices, but this has been more than offset by significant AI-related investment, which has sent global equity markets higher as profits soar. 

If the Middle East conflict de-escalates and oil prices normalise, we believe the macro-outlook for the second half of the year is reasonably strong. Attention may then turn to whether elevated profits are sustainable and whether the AI revolution will negatively impact the labour market in 2027 and beyond. 

But there’s a different medium-term trend impacting bond portfolios today – sticky inflation. Bond yields have been on an upward trajectory since the COVID-19 pandemic unleashed significant government spending in a world of constrained supply. This surge was then boosted by the US’s Liberation Day, the Middle East conflict, massive AI-related investment spending and governments across the globe reaching for the fiscal taps to solve popularity problems.

Trending higher – 10-year government bond yields, %

While these factors might ebb and flow, the underlying trend seems clear. Inflation is proving stickier than hoped, and elevated bond yields are also likely to be a sticky phenomenon. Moreover, while equity valuations and credit spreads have historic reversion tendencies, it is hard to know when bond yields have reached fair value. Investors can be surprised over prolonged periods and can be slow to change their behaviour.

Given this backdrop, what actions do we believe investors can consider as we head into the second half of the year?

1. Be more cautious when investing in long-dated bonds
   Bonds no longer offer simple protection for multi-asset portfolios, so we think it is important to be more cautious when investing in long-dated bonds. For many years before COVID-19, buying long-dated bonds offered yield and protection against economic downturns when an equity portfolio would sell off. In other words, bonds tended to rally when risk assets were weak. In a world of elevated inflation and governments prepared to spend their way out of trouble, bonds can also sell off when equities fall. Long-dated bonds are therefore less valuable for portfolio cushioning.

2. Watch out for credit wobbles impacting equity markets
   A lot has been written about private credit market vulnerability, and this could indeed be a concern if the global economy falls into recession and defaults rise. But assuming a recession is not the base case, the more immediate concern could be a period of indigestion. Public credit markets have absorbed an outsized volume of bond supply related to the AI infrastructure buildout in recent months. So far, the impact on secondary markets has been small – dispersion has increased as investors demand a higher yield for heavy issuers, but average credit spreads remain low compared to history. However, if the impact becomes systemic, particularly if central banks are also tightening credit conditions, then this could be a signal for a more sustained technology sector wobble affecting equity markets.

3. Assess whether the yield pickup for longer-dated bonds is attractive
   Look for government bond curves that are particularly steep, where inflation and fiscal risks are already priced in. This has been the case in Japan for some time now. On the other hand, we believe investors should be cautious when investing in government bonds with little yield compensation, during periods close to important elections or budget announcements. France is a potential candidate for assessment as we head towards next year’s Presidential election.

4. Look to emerging markets
   Fiscal concerns and volatile bond markets are nothing new for emerging market investors, which means risks can be more accurately reflected in markets, while policymakers can be quicker to react. This was the case during COVID-19, and it recurred during the Middle East conflict when several Asian countries, such as Indonesia, the Philippines and India, came under pressure, prompting tighter monetary policy. As tensions reduced, these bond markets saw significant gains. This suggests emerging markets may provide an interesting opportunity for active fixed income investors.

5. Take advantage of the income 
   This may seem to contradict the first point, but here, the reference is not to long-dated bonds, but rather the relatively high yields on offer across credit markets at the shorter end of the curve. This has been the driver behind successful income strategies in recent years, and prospects remain attractive for investors who can successfully harvest income from a range of sources, while keeping duration exposure under control. The major risk here is a global recession leading to rising default risk, but one attraction of holding shorter-dated bonds is that elevated yields can offer risk mitigation against rising credit spreads. 

Shorter-dated credit yields remain elevated, %

6. Be prepared to add duration if recession risk flares up. 
   Having said all this, duration remains your friend if the risk of recession increases significantly. Investors will worry less about inflation and fiscal policy, and more about collapsing activity and central bank rate cuts. But this should only represent a tactical position rather than the systemic exposure of the past, and can be efficiently implemented by asset owners or by underlying portfolio managers.

Risks and opportunities

Macro conditions may have changed permanently, necessitating a different way to invest in bonds. Investors should continue to embrace the income generation of bonds, but not get sucked into buying expensive long-dated bonds. Importantly, there will be relative winners across the bond universe that offer active investors attractive opportunities. And do not ignore signs of indigestion, as this mild disorder could develop into something particularly nasty for debt-dependent technology companies. Bonds are no longer the near-perfect investment of the past, but even with new risks, we believe the asset class still offers plenty of opportunities.

Read more about L&G’s latest insights on the markets here.

 

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Key risk warnings 

The value of investments and the income from them can go down as well as up, and you may not get back the amount invested. Past performance is not a guide to future performance. The details contained here are for information purposes only and do not constitute investment advice or a recommendation or offer to buy or sell any security. The information above is provided on a general basis and does not take into account any individual investor’s circumstances. Any views expressed are those of L&G as at the date of publication. Not for distribution to any person resident in any jurisdiction where such distribution would be contrary to local law or regulation. 

Issued by: 

Hong Kong: Legal & General Investment Management Asia Limited, a Licensed Corporation (CE Number: BBB488) regulated by the Hong Kong Securities and Futures Commission (“SFC”). This material has not been reviewed by the SFC. 

Singapore: LGIM Singapore Pte. Ltd (Company Registration No. 202231876W), regulated by the Monetary Authority of Singapore (“MAS”). This material has not been reviewed by the MAS.

More about our author

Ben joined L&G’s London team in 2008, initially focusing on credit strategy before taking on the role of head of investment strategy and research, coordinating L&G’s research from long-term themes to short-term market drivers. He also chaired the monthly investment macro meeting for many years, a key input for portfolio risk across the active strategies.

He relocated to Hong Kong in 2020, joining the L&G Asset Management Asia Board and was appointed chief investment strategist, Asia, to help grow L&G’s investment business across the APAC region. 

Ben started his career in 1999 as a credit strategist at Dresdner Kleinwort Benson in London, before performing the same role at both BNP Paribas and Lehman Brothers. He holds a Master of Arts in Mathematics from Queen’s College, Cambridge University.

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