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Bonds

Fixed Income | Asset Allocation

Bonds are back

SUMMARY

Early 2022 was a lousy time to be a fixed income investor, but after a collapse in bond valuations and amid a period of slower global growth, Citi’s CIO (Chief Investment Office) now believes current rates of US government bonds look attractive. This year’s extreme sell-off also means the full rate hike cycle is likely already priced in and that investors have a window of opportunity to buy cheap and lock in elevated yields.

STRATEGY IMPLICATIONS

From a yield perspective, senior loans, diversified Emerging Market debt, intermediate-duration IG (investment grade) corporates, municipal bonds for US taxpayers, and preferreds look appealing.

There is, of course, an emphasis on high-quality. Citi analysts have upgraded quality in both fixed income and equity allocations. In high-yield bonds, the strategy is to limit large allocations as a share of overall portfolios and large sector concentrations, particularly for the weakest credit ratings. Since the current tightening cycle is likely to hamper economic growth, Citi analysts do not prefer higher-yielding assets that take exposure to speculative credit.

Although the current spotlight is on bonds, this does not mean that we are abandoning equities. Instead, this re-balancing will provide a much healthier asset class mix while providing a strong foundation regardless of the final market scenario.

WHY BONDS NOW AND NOT IN 6 MONTHS IF YIELDS ARE EXPECTED TO PEAK IN 2022?

Given CIO’s expectation for inflation to peak and consumption to rapidly slow into the second half of 2022, our analysts think the market has already anticipated much of the Fed’s tightening with the risks skewed toward lower rates from here. CIO expects the Fed to raise its policy target to about 2.5% by early 2023. However, bond yields already price in more than this rise. Therefore, our CIO believes current conditions present investors an opportunity to lock in yields at attractive prices.

A CASE FOR STAYING INVESTED

Elevated inflation combined with low interest rates means that cash holdings are losing purchasing power over time. To maintain purchasing power, a portfolio needs to earn a real return (nominal return minus inflation) of zero.

Many investors increased their cash holdings over the past two years in response to the challenging global economic environment. There are now compelling market opportunities where investors can put excess cash to work to earn higher returns.

Chart: Purchasing power of the initial $100 over time  under differing inflation rates

5 REASONS WHY BONDS

1. Bond markets have repriced. The asset class has suffered one of the worst total return periods in its history, with the Bloomberg US Aggregate Bond Index down 10% year-to-date as of May 18, 2022. Put simply, investment-grade bonds are the real buy-the-dip opportunity right now.

2. Rates may stop going up. The Fed will be withdrawing support for the bond market as it raises rates. If inflation retreats and the economy slows, our analysts predict that rates will stop going up, and retreat again in 2023.

3. Rates of 2.5-3.0% on US government bonds look attractive in a period of slower growth.

4. The forward returns for the 10-year US Treasury note were higher after all five periods when both stocks and bonds fell together. The returns for US equities were higher in only three of the five.

5. Diversification. Investment grade (IG) bonds have historically been negatively correlated to equity returns and therefore can help lower portfolio risk.

RISKS

An underestimate of the extent of likely yield increases would mean fixed income assets could suffer further losses. However, Citi CIO’s view is that rates will peak in 2022.