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H2 2023 is looking brighter for fixed income investments due to a variety of factors – good news for insurance investment portfolios that match longer dated liabilities.
The sentiment change comes as the US Federal Reserve (Fed) seems to pause its interest rate hiking cycle. With cooling inflation and simultaneously increasing US Treasury (T-bond) issuance, many are hoping the trend continues into 2024.
Nuwan Goonetilleke, Head of Shareholder Assets at UK-based insurer Phoenix Group, said that he was expecting to see yields increase in the second half of the year – especially in developed markets, which are currently reporting global highs.
He also stressed that it was necessary to remember the fluctuating nature of fixed income investment cycles. “There’s better performance later in the cycle,” he said. “We haven’t quite gotten there yet, and we might see more hikes.”
When asked how fixed income allocations were changing for insurers because of spiking yields and an improving US economy, Goonetilleke noted that whilst global inflation had proved “stickier” than expected, better performance could also mean that fixed income – always an insurance portfolio mainstay – would see stronger inflows.
“I expect better performance as we move through the cycle, and allocations reflect this,” he said.
He urged asset owners not to underestimate the role of historical data. “Historical yields look nice,” he said – adding that the period from December 2023 into January 2024, which brings with it 1:1 renewals, would be of upmost importance. “We could have a Goldilocks scenario, where [yields] are higher for longer,” he said. “[But] the historical basis is attractive, and there will likely be protection from the Fed.”
“I expect better performance as we move through the cycle,
and allocations reflect this.”
A recent analysis from research and ratings agency Morningstar reported that, despite yields “[turning] sharply higher starting midway through July,” bond investors were looking for “more cushion in long term yields”. This was largely due to the possibility that inflation would persist – despite hopes for the opposite.
However, Goonetilleke cautioned that even with inflation factored in, “most people aren’t considering the timing”. He said he was seeing “good value opportunities” in the US for a few reasons – the increasing supply of US T-bonds being a key one.
“Holding longer dated assets should rise 60-70 basis points,” he said. Swaps could outperform treasures in the short term, he predicted, though supply was ultimately a “secondary concern”. The first was the Fed, and if it continued to hike rates or not.
Not all outlooks were as rosy. “More issuance means additional buyers are needed, and on aggregate they need to sell other assets with lower expected cash flows,” said Kaspar Hense, Portfolio Manager at RBC BlueBay Asset Management.
In terms of which specific vehicles are most attractive at the moment, it’s a combination of short duration T-bonds and Investment-Grade (IG) credit that will be catching investors’ eyes.
“More issuance means additional buyers are needed; on aggregate they
need to sell other assets with lower expected cash flows.”
There also no shortage of piqued interest in private markets – especially for those looking for more balanced opportunities throughout the cycle, said Goontilleke. “Real estate is another good area, but some pockets are more challenged than others.”
When it comes to private debt, he predicted that investors will see trends from 2023 continuing: increased allocation and opportunities around refinancing risk.
The secondaries market was also a top consideration. “It’s quickly picking up, and as it matures, we’ll see more people come to the market,” he said. “There are opportunities with infrastructure, especially around net zero and sustainability.”
On the asset management side, allocation was shifting away from equities and cash in favour of fixed income.
“Right now, cash is king. There is uncertainty about for how long, but higher rates will continue to bite,” said Hense. “Real rates are moving up,” he added.
Despite that, he said he thought ten-year treasury yields could remain somewhat elevated, due to the fact that underlying inflation could decline at a slower pace than anticipated. In this scenario, real disposable income would rise, the cycle would be extended, and loose fiscal policy would drive term premiums higher.
“Cash is king. There is uncertainty about for how long,
but higher rates will continue to bite.”
However, cash remained an attractive asset class – at 5.5% in the US – with government bonds coming in second place. Hense predicted that the economy would slow over the next 12 months, with a deteriorating fiscal outlook indicating there would be less room for future growth.
More tightening would have an impact on credit, and he was waiting to see how things played out in the end of H2 through H1 2024. “We still see a range trading environment with regards to duration, but H1 2024 should give more indication,” he said.
Precise allocation was up in the air due to the potential of higher wage growth pushing higher real disposable income up – as well as the risk for a “backflip in inflation” from 2023 into 2024.
One attractive class for Hense was US debt – another typical choice for insurers.
However, he encouraged the distinction between and unhedged and hedged basis. “US debt is attractive on an unhedged basis, but the twin deficit should structurally put pressure on the dollar, which will react when the deterioration of the US economy becomes imminent in the data,” he said. “Again, it feels too early this year, which means it’s a trade for next year.”
The appeal was different on a hedged basis. There, said Hense, the yield curve inversion makes US treasuries less attractive. “Yields, and returns, trade sideways,” he continued. “But the price appreciation will come, and allocators need to prepare for that this year.”
Ultimately, he predicted that US treasuries would be most attractive to – and most frequently purchased by – US investors.
“Bonds at 2.75% to 3% provide a good entry point.”
“European debt will also be catching a bid,” he noted, due mainly to fewer fiscal concerns and weaker economic dynamics. It is also possible that European interest rates are closer to their peak.
Hense's conclusion was that, “bonds at 2.75% to 3% provide a good entry point” – a sentiment that reflects the same optimistically cautious stance around fixed income yields that seems to be prevailing in the market.
The waiting game is not yet over, but little victories could pave the way to a less turbulent landscape.
