Don’t wait for the first cut, now is the time to lock in fixed income returns

I have been fortunate to come into some money recently, via inheritance. It’s not millions (otherwise, I’d be writing this from the beach), but it is what I call ‘hurt’ money—that is, it would hurt to lose it.

Right now, the money is parked in a high-interest savings account, getting just north of 5% on an introductory rate (minus inflation and minus tax – so really, not much at all) and the plan is to ultimately invest it in income-generating assets.

Why am I sharing this story?

Well, it bothers me not at all to admit that fixed income investments are not in my wheelhouse (I have traditionally focused on growth assets, largely equities) and, like a lot of investors, the bond market shenanigans of 2022 are living rent free in my head as I look to make the all-important decision of how to invest. 

So, Livewire’s 2024 Income Series comes at a fortuitous time this year and the goal, as always, is to provide education and sound investment ideas for real investors, with real problems – myself included.

It is even more fortuitous that I recently spoke with Robert Mead, Sydney-based managing director, head of Australia, and co-head of Asia-Pacific portfolio management at PIMCO. In the following, Mead unpacks some bond market myths, gives his considered take on where we are now, explains the concept of "the cost of de-risking", and shares how PIMCO is investing today. 

Time to move on

Right off the bat, Mead is keen to discuss what is reality and what is a myth when it comes to fixed income investing today, conscious that I’m not the only one carrying scars from 2022.

Mead points out that “starting yields matter a lot. The starting yield on your portfolio today is more or less the return you can expect on that portfolio over the next three to five years”.

“Starting yields in 2022 were low, so we shouldn't be surprised by finding things weren't so attractive. 2023, which saw positive returns for bonds, was much more reflective of bond performance when starting yields are higher”.

“So investors should be aware that 2022 was an anomaly in the context of bond market history”.

Mead adds now that rates have reset higher, expected returns going forward will also be higher, offering a compelling income proposition.

According to Mead, the second myth is that diversification is somehow dead.

“When you look at correlations between risk assets and defensive assets, when inflation is well above target, correlations move into positive territory and that's because inflation becomes the dominant driver of returns for all asset classes.

As inflation goes up, that's impacting asset class returns more than anything else. But as inflation comes back down towards Central Bank targets, when you look at all of the historical data across all different markets around the world, correlations also fall”, says Mead

“So as inflation comes back down from these six, seven, eight [percent rates], back to two, three and four [percent rates], correlations between defensive and risky assets fall back to low or even negative.

“That's the scenario we're moving back into and to not acknowledge that the diversification benefits of bonds continue to be incredibly important in a portfolio, I think that would be an oversight”.

The third myth that Mead wants to dispel (and the one which struck a chord with me) concerns waiting for the first rate cut before doing anything.

“If you look at the data, markets move way ahead of the first cut. So waiting is not the right model, but for some reason, some investors out there think it's better to wait”.

"Once they cut, then we're going to pile into bonds... if everyone says that, then that opportunity, by definition, won't work”.

Where are we now?

Having dealt with the scar tissue, I wanted to get Mead’s take on where we are now.

His first point was that active managers, like PIMCO, love volatility: “So the more volatility we get, the better”.

He explains that after many years of central banks and others being directly involved in markets, they're all exiting which allows markets to find their own levels.

“Against that backdrop, we do have tight levels of policy across the board, but the way different economies are reacting to those policy settings is quite divergent, which means there are opportunities to identify which economies are starting to slow the earliest”.

To prove this, Mead points to how many rate cuts have already happened worldwide.

“We've moved into a rate-cutting cycle globally. More cuts are happening every month than hikes. Canada, Switzerland, Europe, all of them have moved into cutting mode”.

Things are happening quickly, adds Mead, and in such an environment, “when it comes to duration positioning or exposure to interest rates, we strongly prefer economies where the most levered borrower has been subject to floating-rate borrowing regimes. That's because borrowers are directly impacted by tight monetary policy bursts. So that's Australia, the UK, Canada, and New Zealand”.

Focus on Australia

Speaking of things moving quickly, Mead points out that it’s easy to forget that only a few years ago, in 2019-2020, 40% of government bonds globally were negative yielding.

“They have moved a massively long way. Through that repricing of interest rates and policy settings, I guess the takeaway is that we've gone from very easy policy to very tight policy in different parts of the world quite quickly”.

When it comes to Australia, “before the RBA even started hiking, our analysis suggested that a rate in the low fours would be sufficient to slow the Australian economy down and bring inflation back to target”, says Mead, who reiterates “We still believe that”.

He goes on to elaborate that the last RBA hike was in November, with the market now pricing in the first cut next year.

“If the market's broadly right, that will be around 18 months of policy at 4.35%. Maybe that's the peak. But as each month goes by and policy remains on the tighter side of neutral, it's impacting the economy every month. The longer you stay at these levels, the less likely you need to hike rates because it's slowly flowing through. As we know, almost every Australian borrower has now moved from a fixed rate to a floating rate mortgage. That was slowly happening over the past year or so. That's almost all done”.

Lots of indicators suggest that the policy setting in Australia is working, according to Mead. “We saw a GDP print that was only slightly positive, so we're sort of on the cusp of recession. We'll probably just avoid it because we've got a 0.1% positive growth number in Q1, but we're on the cusp of growth stalling, and a recession is still possible.”

For the record, PIMCO doesn’t think there will be another hike in Australia, giving that outcome just a 10-15% probability. Mead adds that whilst market pricing for Australia is probably about right, “the big opportunity is after that first cut - there's almost nothing else priced.

“If we do end up getting to the point where we need some support for the economy in terms of easing policy, we don't think one move will be anywhere near enough”.

“When you look a bit further out the yield curve, we think if once the RBA does start moving, they'll move more than the market's current pricing.

That makes us confident of running an overweight interest rate duration position in Australia because we don't think it's fully priced in terms of what would be required as we move into 2025 and 2026”, says Mead. 

What does it mean for returns?

If we had been doing this interview two years ago, we'd be talking about fixed income generating somewhere between 1% and 6% - the latter being the return on high yield bonds.

“But the yields today are somewhere between 6% and 15%”, says Mead.

“The whole world has changed and it takes a while for investors to recalibrate”, adds Mead, pointing out that across asset classes, bonds have recalibrated the most.

“Equities are still near their highs, credit spreads have been reasonably tight, commodities have been strong for a long time, but bonds have gone through a complete repricing”, says Mead.

“The most important thing for any investor is to rethink their own asset allocation in light of the fact that bonds are the only asset class so far that has repriced for the new economic reality”.

Bonds versus other asset classes becoming an easier decision

To explain the changing relationship between asset classes, Mead talks about the concept of “the cost of de-risking” – which he believes right now is quite low.

“With fixed income now offering much lower volatility and a higher expected return, de-risking from some of the asset classes we previously relied on for higher returns when interest rates were low is now much more compelling”.

“Rental yields on residential real estate are still in the threes, fours [percent returns] at best, cap rates on commercial property, again sometimes in the fours and fives, versus daily liquid income generating bond funds at seven”, says Mead

“So it's an attractive asset class in terms of returns and it also offers daily liquidity”.

When it comes to equities, which are trading at all-time highs globally, Mead had the following to say:

“If you are purely in equity markets for their total return, given the levels they’re at now, the total return expectation and the differential between high-quality bond investments and equity investments has narrowed so much.

“The choice to be in one asset class versus the other is almost line ball again, given the higher yields now available in the bond market”.

How are you investing?

If it wasn’t clear already, Mead believes that “the current level of interest rates means that the bond asset class as a whole is attractive”.

That said, a few things stand out in PIMCO’s decision-making process.

There are some areas of risk around vulnerable borrowers, including some of the most levered corporations in the loan market and some parts of the high-yield market.

But the flip side is the opportunity to be exposed to very well-protected borrowers, US households that are also well-protected, and investment-grade corporations, which are "very well-protected by borrowing, long-dated at low yields”, adds Mead.

“When it comes to credit, those sectors stand out as being very defensive”, says Mead.

“Further down the credit curve, we still like some elements in the private credit space, but we're very selective since certain parts of the private credit market are incredibly crowded”.

Invest with the world's premier fixed income manager

For more insights from Rob and the team at PIMCO, please visit their website, or see the Fund Profiles below. .

Managed Fund

PIMCO Diversified Fixed Interest Fund

Australian Fixed Income

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Managed Fund

PIMCO Income Fund

Global Fixed Income

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