Are high quality bonds primed to bloom in 2023?

Every so often, ideal conditions present themselves. For the titan arum – the world’s largest unbranched flower – it can be anything between two to ten years between blooms, but when it flowers, the results are impressive. John Pattullo and Jenna Barnard, Co-Heads of Global Bonds at Janus Henderson Investors, believe high quality investment grade bonds, especially government bonds, are in a similar sweet spot heading into 2023, as a confluence of attractive yields and an inflection point in rates opens up the potential for strong returns.

Attractive yields

For bond markets, policy tightening in 2022 to tackle inflation was painful as yields rose. Yet the price correction lifted government bond yields back to levels not seen in more than a decade. It was a similar story with investment grade corporate bonds where both credit spreads (the difference in yield between corporate bonds and government bonds of similar maturity) and yields moved higher.

Figure 1: Yields on government bonds

2023 is an inflection point

Attractive income levels on bonds, however, are only half the picture. We think 2023 will also be an inflection point for rates – as central banks shift their policy in response to declining inflation and an economic downturn.

Bond yields have often overshot when core inflation spikes heading into an economic downturn. This decoupling of government bond yields from economic prospects occurred in 2022 as bond yields rose despite manufacturing new orders declining. We expect government bond yields to recouple with the economic data. From above 4% in the fourth quarter of 2022, we think the US 10-year government bond yield could be close to 2% by the end of 2023. This could lead to strong capital gains on government bonds and should also have positive implications for better quality investment grade corporate bonds, since these bonds are typically sensitive to rate moves.

There is no guarantee that past trends will continue or forecasts will be realised.

‘When’ not ‘if’ employment turns

We think we are progressing through a typical economic cycle, with the over-stimulus of the past couple of years giving way to a downturn and recession as policy tightening bites. Pain is already being felt in the housing market and corporate earnings appear to be peaking. We think it is only a matter of time before US non-farm payrolls begin to reflect other employment data that companies are shedding jobs.

Back in the 1970s and 1980s, the US Federal Reserve (Fed) hiked rates until it had control of inflation and then immediately started cutting. Its tolerance of rising unemployment was low. We think the Fed will take fright and start cutting rates after a few negative non-farm payroll prints – and this could come as early as the first half of 2023.

Inflation on the turn

This shift in policy is reliant on inflation coming down but inflation looks to already have peaked in the US and could come down rapidly in 2023 in Europe as well despite the energy crisis distortions. Commodity and freight prices have tumbled and a collapse in broad money growth also suggests that the upsurge in inflation is set to wash out over the course of 2023.

The risk to our view is that the jobs market remains robust and inflation refuses to fall. If that is the case, however, then we would expect to see central bank policy being more restrictive and the economic downturn being even more severe – an outcome that would ultimately favour higher rated bonds. As we see it, we think there is simply too much data stacking up in favour of our view that investment grade government and corporate bonds can put on a strong display in 2023. For more information, please visit www.janushenderson.com