For financial advisers and professional investors only – not for distribution to retail investors.
19 May 2023
Bonds might be back but how should you time re-entry?
There has been a historic bond market repricing over the past year, leaving fixed income investors with returns as bad as any time in the last 100 years. However, these large price moves have produced sharply higher yields. Higher yields mean the forward-looking return profile in fixed income looks increasingly attractive. But timing the market is fraught with difficulties: balancing the better forward-looking yields on offer, against continued elevated inflation, the likelihood of more market volatility, and fragile sentiment. How can investors judge when is the right time to increase bond holdings?
We believe that it’s reasonable to start building into investment positions as the risk-reward begins to skew in the favour of bonds, recognising that missing out on a turning point can be at least as painful as being too early.
Market timing is difficult, and it’s naïve to believe we can reliably pick turning points – particularly in such a volatile market environment. However, history can act as a guide - in fixed income markets and specifically government bond markets, yields have tended to peak around the timing of the last rate hike in a hiking cycle, and in most historical cases have rallied strongly following that point.
Chart 1: US Treasury Yield and US Federal Funds Rate – Yields tend to peak around the last rate hike
Source: Bloomberg.
Of course the timing of the end of the rate hiking cycle can be unclear and is often impossible to know until after the event– so consider three broad alternative strategies, each with a one year horizon: Firstly, timing the end of the hiking cycle (the last hike) perfectly; secondly, being 3 months too early to the last rate hike; and finally, wanting certainty that the hiking cycle is over: that is, waiting to see the first cut in rates.
1. Timed to perfection
Getting the timing perfect is obviously attractive, but unlikely: in each historical case, an investor would have captured at least 1% of yield compression over the next year - with the sole exception of 2006, where yields ended unchanged, as shown in Chart 2.
Chart 2: Bond yields consistently fall after the final rate hike in a cycle
2. The early bird gets the worm
But what if you are too early? Assume an investor moves 3 months too early, and suffers some losses in the short term. Being somewhat early to the trade has not been overly costly historically, with at worst a further 0.40% of yield rises in the short term. However, again this has historically been followed by quite consistent gains: averaging a 1% fall in yields over the subsequent year. Based on historical periods, assuming investors were able to accept modest losses in the short term, they were subsequently rewarded with relatively strong and consistent returns over the medium term. This historical trend is shown in Chart 3.
Chart 3: 3 months too early? Bond yields still consistently fell
3. Late to the party, risk missing out on cake
Critically, though, if investors were to wait for confirmation of a change in the environment (that is, waiting for the first cut in interest rates), the bulk of the bond gains will already have been made. Bond yields move ahead of central bank rate decisions, anticipating changes in the economy and therefore the path of rates – so once it becomes ‘obvious’ that rate cuts are coming, it’s likely to be too late. Historically, over the year after the first cut in rates, bond performance is mixed: there is still strong performance remaining in some periods (but notably, none better than moving a little too early), but for other periods, the low in yields is already well past, and yields actually rise over the next year, as seen in Chart 4.
Chart 4: Waiting for a CUT means missing out on performance
The outlook for fixed income markets is starting to offer attractive and higher yielding opportunities following the sharp repricing in global fixed income markets. As a result, many investors are now reviewing their portfolios considering whether an increased allocation to fixed income is appropriate. The natural next question is, if so, when? Ultimately, there is no perfect recipe for timing an entry into bonds, but historically, it has proven better to be early to a turnaround in bond yields rather than late.
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