Party not over for UK short-dated bonds with Bank of England poised to pivot
The ‘party is not over’ for short-dated bonds despite their recent recovery, with returns set to be supported by a looming Bank of England pivot amid growing fears of a UK recession, according to AXA Investment Managers’ Nicolas Trindade.
Following a ‘brutal’ 2022 the first few weeks of the year have seen bond markets begin to regain ground as lower gilt yields and tighter credit spreads have helped short-dated sterling credit perform well.
While investors may be questioning how long the opportunity in the asset class might last, Trindade, who manages short duration strategies at AXA IM, says there are good reasons to believe 2023 will continue to be a profitable one for those staying the course.
“The recent recovery has been good news for investors who added to allocations in the last months of 2022, but we believe it has some way to go,” he says. “Yields remain high and provide an attractive jumping in point, and the current economic climate could provide the impetus for above-inflation returns in 2023.”
With inflationary pressures widely expected to ease in the UK over the year and a recession looming, Trindade says a major supporting factor for short-dated bonds is likely to be a reversal of central bank policy in the second half of 2023.
“If the UK tips into a recession later in the year, which is probable, then the combined effect is likely to see the Bank of England row back on interest rates,” he says. “That would provide an uplift for sterling short-dated credit, as the yield curve would ‘bull steepen’, meaning that short-dated yields would fall by more than longer-dated ones.”
Moreover, Trindade points out that with the gilt yield curve still flat – and the sterling credit curve downward slopping – investors remain unrewarded for increasing the duration of portfolios.
“Valuations are simply more attractive at the front-end of the curve, with short-dated bonds continuing to offer higher yields,” he says.
In addition, Trindade says that with the cash prices of many short-dated bonds continuing to trade well below par (100p), investors can still enjoy the natural upside they offer as they mature.
“Indeed, we believe that the capital appreciation of bonds could be one of the primary drivers for return in 2023. We still believe markets will remain volatile due to inflationary pressures and a high risk of recession in UK. But despite the recent rally, there is still ample room to benefit from attractive levels of yields and valuations over the medium term.”