The “Magnificent 7” reasons why now is a good time to invest in core bonds

On February 18, the Reserve Bank of Australia (RBA) announced it was cutting the cash rate a quarter point to 4.1%. This marks the first rate cut since November 2020—when the RBA took steps to combat a slowing economy during the pandemic—and follows 13 rate hikes in the intervening years.

While the market is currently pricing for two more rate cuts this year, at PIMCO, we expect three more 25 bp cuts. Our rationale is that inflation has fallen firmly within the RBA’ s target band (where we expect it to remain), household spending and business investment has been flat for 12 months, and government spending is almost entirely responsible for the fact that the economy is growing not stagnating.

In this era of rising uncertainty and falling cash rates, we have identified the “Magnificent 7” reasons to include core bonds as a strategic allocation in portfolios.

1. Uncertainty is certain

The current economic landscape is fraught with uncertainty, as we noted in our recent Cyclical Outlook, “Uncertainty is Certain”. The change in U.S. leadership increases global economic uncertainty in 2025, with potential policy pivots in the U.S. that have the potential to reshape trade relationships and alter economic dynamics worldwide. We appear to have seen the peak in U.S. economic outperformance and we expect inflation across developed markets (DMs) to continue converging towards target levels as labour markets cool. As a result, DM central banks, including the RBA, should have ample room for interest rate cuts in 2025.

2. Developed market inflation is normalising

Headline inflation across DMs is trending back towards target levels. In Australia, core inflation, when annualised over the last two quarters, is close to the midpoint of the RBA’s 2%-3% target range. While services inflation remains somewhat sticky due to tight labour markets, signs of easing are emerging as wage growth slows and inflationary pressures diminish. The absence of employment growth in the ex-government sector further supports this trend and we expect an increase in the unemployment rate to the mid-4% range.

3. Cash rates are falling

Even before the RBA’s February rate cut, Australian banks had begun to lower term deposit interest rates, with significant implications for Australian savers who rely on this steady income. In fact, core bonds are now yielding more than cash equivalents, enhancing their expected returns.

With further rate cuts on the horizon, the attractiveness of bonds relative to cash will only continue to grow. Additionally, bonds, unlike cash, stand to benefit from capital appreciation as policy rates fall, reinforcing their role as a diversifier and stabiliser for equity exposure in portfolios.

4. Equities are expensive

A common equity gauge, the cyclically adjusted price-to-earnings (CAPE) ratio, has climbed to levels previously seen only twice in the past three decades: during the dot-com bubble and the post-pandemic recovery (for more, see “Where to Look When Equities Are Priced for Exceptionalism”). Financial markets seem to be pricing in a very positive baseline expectation at a time of elevated geopolitical uncertainty. As central banks work to bring inflation back to target, the negative correlations between high-quality bonds and equities are reasserting themselves. This dynamic underscores the diversification benefits of incorporating bonds in a portfolio, especially in a climate of rich equity valuations and heightened volatility.

5. Defaults and restructurings are accelerating

The financial media is rife with reports of defaults and restructurings, particularly within property development and hospitality sectors. Investors should remain vigilant about portfolio concentration and explore global relative value and diversification opportunities.

6. Hybrids are disappearing

As hybrids begin to be phased out, investors should be cautious about how they replace the franking credits associated with hybrids. We would advise against trying to match those yields by moving from a relatively low risk investment solely into illiquid, high risk credit investments, particularly in sectors that are facing meaningful stress at the moment, such as property development and construction. Instead, investors can consider incorporating core bond funds, bond ETFs, and income funds into portfolios to maintain liquidity while achieving yields around 5%-6%.

7. Core bond yields are high

The bond market presents a wealth of attractive opportunities, with yields significantly higher than pre-pandemic levels. This trend is consistent across global bond markets, including Australia. The correlation between starting yields and bond returns is robust, with approximately 95% of expected returns over the next five years attributable to starting yields. Consequently, higher starting yields suggest a more promising outlook for bonds in the latter half of this decade, especially when compared to equity valuations which are hovering near historical highs.

Now is an opportune time to diversify portfolios with core bonds

In an environment characterized by elevated uncertainty and market volatility, it is more important than ever to maintain disciplined portfolio construction principles. This includes ensuring that portfolios contain sufficient diversification to mitigate downside risk associated with growth assets such as equities. In addition, as the hybrid market phases out, investors should avoid the temptation to substitute franking credits solely with riskier, illiquid credit.

With market volatility likely here to stay, we believe active bond funds and ETFs can play a vital role in portfolios, offering defence, diversification and income generation.

Find out more about PIMCO’s new range of active fixed income ETFs here.