After years of extremely low interest rates, fixed income investments have become an attractive asset class again. Jeroen van Herwaarden, Portfolio Manager of Triodos Euro Bond Impact Fund, explains why it is a good time to invest in fixed income and how investing for positive environmental or social change may contribute to lowering credit risk.
When global inflation started rising strongly in 2022 after the COVID-induced lockdowns, central banks were initially convinced this rise would be transitory in nature. When it became clear the rise was much more prolonged, with the war in Ukraine and second-round effects like wage increases leading to extra price pressures, global central banks embarked on an unprecedented monetary tightening path. The subsequent rate hikes pushed up both short- and long-term interest rates to their highest levels in a decade.
Yield-to-maturity on balanced investment-grade portfolio now above 3%
Now that the peak in inflation is behind us and, after two years of unprecedented tightening, most central banks have reached the end of the rate hike cycle, the smoke seems to have cleared. Inflation has been falling last year and can be expected to fall further towards the central banks’ target of around 2 percent. As a result, financial markets expect central banks to start cutting interest rates in the first half of this year. All things equal, euro-based bond investors are now rewarded a decent annual return of more than 3% on a balanced portfolio of investment-grade bonds with an average duration of five years. This return does not only compare attractively to cash returns like the interest on a savings account, but it also provides bond investors with a buffer against adverse interest rate developments going forward. An additional advantage of these higher interest rates is that bond investments may increasingly start taking on their traditional role in a balanced investment portfolio again: to provide protection in periods of unfavourable equity performance.
Possible additional return to bond holders on top of attractive interest rates
If inflation keeps falling and economic activity slows down further over the following months, bond holders may expect an extra return from declining long-term yields. In addition, if the main central banks indeed cut rates this year by the currently expected magnitude or more, falling short-term interest rates may further add to bond investors’ total returns. But even if current inflation proves sticky and rate cuts occur later than expected, bond investors can still make a solid return based on the current yield levels.
Deteriorating company fundamentals ask for defensive positioning
We expect credit spreads to widen in the first half of this year, as tighter monetary conditions will start hurting the profitability of debt-heavy companies. The expected environment of weakening company fundamentals and rising default rates asks for a defensive positioning in terms of credit risk. As a result of our prudent investment policy and the defensive positioning of the Triodos fixed income investment portfolios, credit risk is considerably lower in our funds compared to the reference index.
Impact strategy accounts for fully impact-related profile and lower credit risk
We invest for positive change, alongside a financial risk and return that are in line with the broader market. Inherent to our impact strategy, selected issuers have, besides generating positive impact, considerably lower sustainability risks compared to the overall market. In addition, we invest to a large extent in ‘use-of-proceeds bonds’, a type of impact bonds of which the proceeds are earmarked to finance eligible environmental and/or social projects. Use-of-proceeds bonds are a strong instrument to steer the investments towards more positive impact. The issuer of the bond, moreover, is obliged to report on the impact results. Impact bonds have therefore become an important asset in our bond portfolios, currently accounting for two thirds of our euro-denominated fixed income investments. The market for impact bonds has become more mature over the past years, with more and more corporate issuers entering the market. But as the market for impact bonds still consists to a large extend of green- and social bonds issued by large government-related issuers, our fixed income portfolios have by nature of their impact strategy a large allocation to higher-quality impact bonds, which means a lower exposure to spread volatility.
In conclusion: attractive yield and resilience
In current market circ*mstances, with higher bond yields, fixed income investments have become an attractive asset class again from a risk-return perspective. Apart from the attractive yield, bonds also offer resilience for adverse market developments in risk assets like equities. Impact bonds add additional value by generating positive impact and contributing to lowering overall credit risk through the higher average quality of the issuers.
Answer: Now may be the perfect time to invest in bonds. Yields are at levels you could only dream of 15 years ago, so you'd be locking in substantial, regular income. And, of course, bonds act as a diversifier to your stock portfolio.
With this possibility in mind, the outlook for fixed income looks bright, especially given the relatively high starting point for bond yields. One only needs to look back a few years to see how much more yield bonds now offer investors.
In general, prices rise as yields fall in fixed income. So, investing in higher-yielding fixed income today could capture yield with the potential for positive price performance should market yields continue to fall, tracking cash investment yields lower along with Fed rate cuts.
With interest rates as high as they've been for 16 years, but with many experts predicting they may fall in the coming months, it could be a good time to take advantage of fixed-rate bonds.
Positive Signals for Future Returns. At the beginning of 2024, bond yields, the rate of return they generate for investors, were near post-financial crisis highs1—and for fixed-income, yields have historically served as a good proxy for future returns.
Interest rates tend to begin to decline three months ahead of recessions and reach a cycle low about five months into recessions. During economic downturns, fixed income has been shown to provide diversification benefits and reduce the volatility of portfolios that include risk assets such as equities.
Interest rate changes are the primary culprit when bond exchange-traded funds (ETFs) lose value. As interest rates rise, the prices of existing bonds fall, which impacts the value of the ETFs holding these assets.
While traditional fixed income has struggled so far in 2024, emerging markets debt (EMD) has proved more resilient, outperforming the broad U.S. investment grade bond market (1.58% to -1.64%, according to respective Bloomberg indexes).
In current market circ*mstances, with higher bond yields, fixed income investments have become an attractive asset class again from a risk-return perspective. Apart from the attractive yield, bonds also offer resilience for adverse market developments in risk assets like equities.
First and foremost, creating a detailed budget is the key. Start by listing all your income sources, including pensions, Social Security, required retirement account distributions, or any other fixed payments. Next, prioritize essential needs such as housing, utilities, transportation, groceries, and healthcare.
This is because when interest rates rise, new bonds are issued with higher yields, making existing bonds with lower yields less attractive to investors. It is important to note that not all fixed income securities are equally affected by rising interest rates.
Should I only buy bonds when interest rates are high? There are advantages to purchasing bonds after interest rates have risen. Along with generating a larger income stream, such bonds may be subject to less interest rate risk, as there may be a reduced chance of rates moving significantly higher from current levels.
Given where we are now (i.e., post-Covid, falling inflation, higher rates, restoration of bonds' diversification benefits), we believe that the case for fixed-income is very strong. Although cash rates are currently attractive, investment-grade credit yields are currently offering outperformance.
Why Trust Us? As of June 2024, no banks are offering 7% interest rates on savings accounts. Two credit unions have high-interest checking accounts: Landmark Credit Union Premium Checking with 7.50% APY and OnPath Credit Union High Yield Checking with 7.00% APY.
We expect bond yields to decline in line with falling inflation and slower economic growth, but uncertainty about the Federal Reserve's policy moves will likely be a source of volatility. Nonetheless, we are optimistic that fixed income will deliver positive returns in 2024.
When the RBI cuts rates, banks and NBFCs usually follow suit by lowering the fixed deposit interest rate. This means the attractive rates we're seeing now might not stick around for long. By investing in Fixed Deposits(FDs) now, you can lock in the higher interest rates before they potentially drop.
If you decide to sell a bond before its maturity, the price you receive could result in a loss or gain depending on the current interest rate environment. The longer a bond's maturity—or the longer the average duration for a bond fund—the greater the impact a change in interest rates can have on its price.
What causes bond prices to fall? Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher. If bond yields rise, existing bonds lose value.
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