The outlook for fixed income in 2024

Fixed income now has greater income potential than before the financial crisis in 2008.

Gurpreet Gill said with developed market government bonds on track to deliver negative returns for the second consecutive year, there is now greater income potential in fixed income.

The macro strategist for global fixed income at Goldman Sachs Asset Management said: “The recent shift from a low-yield environment has been challenging for investors, with developed market government bonds on track to deliver negative returns for the second consecutive year. However, this challenging journey has also led to a greater income potential in fixed income than we have seen since before the Great Financial Crisis. 

“In the face of structural shifts such as decarbonisation, deglobalisation, and geopolitical instability, investors are increasingly concerned about growth volatility and bearish market sentiment. In 2023, investors responded by turning to cash. While front-end yields remain attractive, we believe a return to core fixed income is warranted going forward. 

“Amid the transition from zero to higher yields, we believe bonds can play a crucial role in balancing portfolios. The recent rise in yields has created room for them to fall and buffer declines in other assets. Additionally, the correlation between core bonds and risk assets is expected to return and stay negative as disinflation progresses, further enhancing the portfolio value of bonds.”

She added that the uncertain economic environment calls for a rotation back up the quality spectrum into investment grade (IG) government and corporate bonds, as well as agency mortgage-backed securities (MBS). 

Gill added: “Growing differentiation in fundamentals warrants an active approach to bond selection. While debt servicing capacity for many IG-rated companies remains healthy, liquidity positions have eroded, diminishing resilience to unexpected shocks. Additionally, as newly issued, higher-yield debt replaces older, lower-yield debt, the average cost of funding will rise.

 “Ongoing disinflation is expected to forge a more predictable path for monetary policy and dampen rate volatility. This could potentially allow MBS spreads, which are remarkably wide for an asset class that carries virtually no credit risk, to tighten.

 “The transition to a higher cost of capital environment is likely to involve a further uptick in financial distress and defaults among issuers with over-leveraged balance sheets sensitive to rates. High long-term US rates have already caused some emerging market (EM) sovereigns to lose market access, generating defaults and debt distress. Moving further into a higher rate regime may expose further vulnerabilities, including resurfacing sovereign debt risks in Europe and broader EM sovereign distress.

“Ultimately, we anticipate more dispersion at a macro and micro level, and therefore more investment opportunities in fixed income sectors and across interest rates and currencies.”

Diversification is key

Asset managers are also anticipating that high quality fixed income will deliver decent risk-adjusted returns next year, according to Becky O’Connor.

The director of public affairs at PensionBee said: “Many asset managers are expecting that high quality fixed income will deliver decent risk-adjusted returns throughout 2024, despite higher interest rates creating a more challenging environment for businesses. Fixed income occupies a greater proportion of a pension plan as savers reach their retirement years. While risks remain, greater stability should also improve returns for fixed income and older savers should benefit from more stable returns on their retirement pots.”

This was echoed by Rachel Titchen, who agreed that fixed income offers consistent income during times of global pressure. 

The charities and investment director at consultancy Broadstone, said: “With the recent improvement in funding positions, a larger portion of UK defined benefit (DB) pension portfolios is now allocated to fixed income securities. These assets, including bonds, offer consistent income and capital preservation - a crucial attribute as interest rates face pressure globally. Broadstone regards fixed income as an essential asset class for UK DB pension funds, offering stability in a turbulent market and protection against potential interest rate decreases.”

Peter Hall, partner for Momentum Investment Solutions & Consulting, said most of its clients have been allocating to investment grade rated fixed income. 

He said: “For fixed income assets, we focus on the credit spread that is available over and above government bond yields.  We acknowledge that overall yield levels have increased significantly but the majority of that has been from an increase in risk free yields which is reflected in our clients liability hedging portfolios.  Credit spreads have tightened over the year as corporate fundamentals have remained relatively strong, however, spreads remain above average historic levels and still offer reasonable returns for investors in our view.  

“However, in the current higher interest rate environment there remains the potential for pockets of stress within certain sectors if not the risk of broad based recession.  As such, our preference is to be well diversified and higher in quality and most of our clients have been allocating to investment grade rated fixed income.  These assets can also form a helpful part of a ‘collateral waterfall’ and are an important allocation for pension schemes that are wanting to maintain a higher level of liquidity and a higher level of resilience to yield rises within their liability hedging mandates.”

The positive outlook for fixed income was reiterated by Adam Gillespie.

Gillespie, who is a member of the Society of Pension Professionals’ investment committee, said: “Overall yields are very attractive, meaning high levels of cashflow generation are available for schemes to meet benefit payments.”

He added that spreads, which is the difference between the yield available on corporate debt and low-risk government debt, are not pricing in a recession and sit below long-term historical averages.

He added that defaults have picked up, albeit from a very low base. 

Gillespie added: “We expect to see defaults rise further in 2024, as company interest cost continues to squeeze company margins, but not to unreasonable levels.

“Expect significant flows into investment grade corps (particularly sterling bonds) to continue from DB pension schemes as they de-risk.”

He called for a sharper focus on the structure of UK’s DB scheme liquid credit mandates.

Gillespie said: “Sharper focus on the structure of UK DB scheme liquid credit mandates is required as they become a larger part of scheme overall portfolios. This is likely to prompt the necessity of looking further afield than just sterling bonds into non-sterling investment grade bonds, emerging market debt and asset backed securities, to ensure schemes avoid certain concentration risks that can build up otherwise.”