The consensus that developed early in 2023 – that higher bond yields marked a significant investment opportunity – drove a notable shift in asset allocation. Family offices were among the investors who subsequently piled into fixed income. But yields have kept on rising and investors have now been left hoping that 2024 brings about a change in fortunes.
Higher-than-expected yields threaten family offices’ move into bonds
Following the consensus
In its annual Global Family Office Report, published in May, UBS announced that family offices were planning the biggest shift in asset allocation in a number of years as fixed income returned to favour. 1 And recent reports suggest that’s exactly what has happened. The results of a survey conducted by Citigroup and released in September show that family offices have reduced their exposure to equities while increasing their allocations to fixed income.
Citigroup said the move marked ‘the most substantial change’ in family-office positioning since 2020. More than half of the surveyed entities had increased their fixed-income allocations, with these offices controlling a cumulative total of $568 billion in assets. 2
The big swing into bonds
It’s not just family offices that have changed their position. By October, bonds were by far the favourite asset class of all types of investors – relative to their historic portfolio weightings – according to a survey of fund managers that Bank of America carried out during the same month. 3
The shift reflects the sea change that has taken place in fixed-income markets over the past three years. After decades of falling yields, rising inflation – and increased borrowing costs – bonds now offer much better value. In mid-October, for example, benchmark 10-year Treasury yields rose to their highest level since 2007. 4 The realisation that US interest rates will stay ‘higher for longer’ than anticipated, given the resilience of US inflation, prompted the rise in yields.
However, core government bonds are also benefiting from geopolitical instability in various parts of the world. The continuing war in Ukraine and fears about China’s intentions towards Taiwan, for example, are driving investors into havens such as Treasuries.
Starting points for yields are a key indicator of future returns from fixed income, so now should be a good time to invest in bonds. However, investors who piled into fixed income earlier this year after a strong rise in yields in 2022 are now nursing potential losses as yields have continued to rise much higher than expected this year. At the beginning of 2023, 10-year Treasury yields stood at just 3.5%, but the figure is now close to 5%.
Yields have risen further than markets anticipated this year
As a result, bond investors could be facing another year of negative returns, after the significant declines seen in 2022. Indeed, according to Edward McQuarrie, professor emeritus at Santa Clara University, US bonds suffered their worst year ever in 2022. 5 By 19 October 2023, the Bloomberg Aggregate Bond Index – which tracks investment-grade debt like Treasuries and is the benchmark for many of the world’s largest passive bond funds – was down more than 4% over the year to date. 6
Reasons to be cheerful
However, there are reasons to believe bonds can still deliver positive returns this year. For one thing, soaring yields could, in themselves, end up slowing the economy and cooling inflation, thereby allowing the Federal Reserve to end the cycle of rate hikes. That’s according to no less than Jay Powell, the chairman of the US central bank, who was speaking in October after the 10-year Treasury yield nearly breached 5%. 7
Moreover, consensus forecasts suggest US and global growth will slow and inflation pressures will ease next year, providing scope for rate cuts and lower yields. The Conference Board, for example, forecasts that US economic growth ‘will buckle under mounting headwinds early next year, leading to a very short and shallow recession’. It anticipates real GDP growth will reach 2.2% in 2023, and then fall to 0.8% in 2024. In the second half of 2024, it expects that overall growth ‘will return to more stable pre-pandemic rates, inflation will drift closer to 2%, and the Fed will lower rates to near 4%’. 8
Although the US economy has remained surprisingly resilient, there are indeed sound reasons to believe it will now soften. For example, the Conference Board argues that government spending, which has supported growth in 2023, will act as ‘a drag on growth later this year and early next’. Moreover, the Federal Reserve now believes that the savings squirrelled away during the pandemic are just about gone. The spending of those savings has also boosted the economy. 9
If economic growth and interest rates have reached their peak in the US, the eurozone and the UK, then yields could start to ebb later this year as the economic outlook for 2024 deteriorates. That would mean fixed-income investors – including family offices – might just escape another year of negative returns. Moreover, returns could turn strongly positive from next year as growth and inflation slow, and central banks loosen monetary policy.
3 https://www.ft.com/content/62430601-8c87-4d27-a440-db78f5250a71
4 https://www.ft.com/content/8e75f00b-b802-4161-a67c-7c51c5ba9f5c
6 https://www.bloomberg.com/quote/LEGATRUU:IND
7 https://edition.cnn.com/2023/10/19/economy/fed-jerome-powell-economic-club-of-new-york/index.html
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