As you can see from Figure 4, nominal yields for both US and European investment grade bonds are at levels not seen for more than ten years. More importantly, they are both offering real rates of return after expected inflation – again at levels not seen since the Global Financial and Euro Crises.
They are also comfortably ahead of equity dividend yields – so our analysis from last year1 remains valid. In other words, bonds are once again a viable option for investors as they look to meet their return goals.
Reflecting on what this environment means for pension schemes specifically, Ashar Muhammad drew attention to some changes in asset allocation trends. Ashar is a member of Invesco’s UK Pensions and Consultant Relations team. He commented:
“The LDI crisis last year was a difficult time for most UK DB schemes, but they have generally come out of it with improved funding levels. As investment strategy reviews are underway, there are some broad asset allocation trends that we are already observing – a greater focus on liquidity, portfolio de-risking, and a better appreciation of the desired endgame. Going forward, we expect an increased allocation to fixed income, especially buy and maintain credit, which is ideally placed to meet the emerging needs of UK DB schemes”.
We expect yields to peak as monetary policy bites
Could yields continue higher? Of course, but probably only as the result of a deterioration in the corporate outlook, higher inflation, or a more aggressive central bank policy stance.
Our team’s base case, however, is inclined towards a topping out due to slowing inflation and growth as restrictive monetary policy bites. Softening forward-looking indicators such as the Purchasing Managers’ Index (which tracks economic trends from private sector manufacturing and service companies) seem to support this thesis.
We are overweight duration2 in our benchmark-aware accounts, particularly in the UK and front-end US.3 We also think that buy and maintain investors have a potential opportunity to take advantage of these positive real returns for the longer term.