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Is it time to move back into bonds?

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This is a sponsored article from Capital Group.

Haran Karunakaran, investment director, Capital Group, shares his views on the investment implications as inflation eases and central banks move towards rate cuts.

The last few months have seen a significant change in the macroeconomic environment. Policy rates appear to have peaked, and central banks around the world are gradually preparing for a period of interest rate cuts.

This shift from hiking to cutting will likely have significant implications on market returns. History suggests it may be negative for the large cash allocations that many investors hold today, with rate cuts transmitting directly into a rapid decay in cash yields.

By contrast, these inflection points have historically been positive for high-quality bonds, which see outsized capital gains from yields falling.

The end of a rate hiking cycle is good for bonds

Following the peak of a rate cycle, high-quality bonds (proxied by the Bloomberg US Corporate Bond Index) have delivered, on average, a cumulative return of 32% over a three-year horizon. That is double the average return on cash (proxied by the JP Morgan USD three-month cash index) – an exceptional result for a very high-quality and defensive asset. The turn in the interest rate cycle provides a rare return opportunity for high-quality bonds.

Average cumulative return from investing at the peak of the Fed funds rate in previous cycles

Why do bonds outperform cash from the peak of a rate cycle?

As central banks cut rates, high-quality bonds should deliver strong returns due to two positive forces:

  • Yield advantage: High-quality fixed income typically offers investors a higher yield than cash-like investments. Over multiple years, this yield advantage compounds into a significant wealth difference for investors.
  • Capital appreciation: As central banks shift from hiking to cutting rates, fixed income instruments benefit from price gains. For example, US corporate bonds today have a duration of around seven years. This means if yields were to fall by 1%, the bonds would generate a 7% capital gain. This is on top of the yield advantage the bonds may continue to earn.

Essentially, by investing toward the peak of a rate cycle, bond investors can lock in attractive yield levels, which typically drive strong returns for years to come. By contrast, rate cuts are negative for investments in cash-like instruments. Consider an investor who can today access a three-month term deposit paying 4% per annum. As central bank rate cuts are priced in, this term deposit rate will likely fall — based on previous cycles, the initial 4% p.a. offered could end up at just 1.8% p.a. The term deposit investor’s realised return over a multi-year period will be much less than they may have anticipated at the outset.

Implications for investors today

As investors consider the defensive portion of their portfolios, two key points should be kept in mind.

First, the defensive allocation is more important today than it has been in many years. We are in a macro environment of elevated risk, whether that be geopolitical tensions or election-related volatility. Investors once again will need to lean on their defensive allocations to provide stability for their portfolio. High-quality fixed income can provide investors with key defensive characteristics, namely capital preservation and diversification against equity market volatility.

Second, the current environment provides a rare return opportunity for bond investors. Bond yields remain near decade highs; investing today allows investors to lock in these yields for years to come. If central banks do cut rates over the next few years, this would provide an additional (and likely significant) tailwind for bond returns. By contrast, a falling rate environment would be negative for cash allocations as rate cuts immediately pass through to a decaying cash yield.

The outlook for high-quality fixed income today is more exciting than it has been in many years. History tells us that the expected inflection in monetary policy will likely lead to diminishing returns for cash but provide a very positive environment for high-quality bonds. Is now the time to make this shift? The current environment provides the chance for investors to take advantage of a rare opportunity in high-quality bonds to bolster their defensive allocation.

For more thought leadership articles on fixed income from Capital Group, please click here.

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This is a sponsored article from Capital Group.

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