Fixed income to play outsized role in 2024

Investors should be able to realise relatively strong returns from fixed income investments in 2024, with the previously high correlation between equities and bond markets continuing to fade over the next year, researchers from US investment firm Franklin Templeton have argued.

Stephen Dover, who heads the firm’s research house Franklin Templeton Institute, noted a predicted softening in inflation, as well as economic and employment data, in the US, with prior inflation-busting rate hikes by the Federal Reserve still working their way through the economy.

As such, fixed income will likely prove a more compelling ‘safe-haven’ asset over cash, serving an increasingly “valuable role within a balanced portfolio”.

With the US economy predicted by many to slow, Dover said the market was pricing in as many as four interest-rate cuts in 2024 – however, there was debate from fellow Franklin colleagues on the pace and severity of the economic retreat and the forecast number of rate cuts from the Fed in response.

Regardless of the economic outlook, the Franklin researchers argued that continued decoupling of bonds from equities performance over the next year will create a compelling “entry point for longer-duration assets”, one that is “perhaps the best seen in a decade”.

“The case for fixed income seems quite strong, particularly for investors looking to move some portion of their portfolios out of cash,” Dover said.

Dover added: “The correlation between equity and fixed income has dropped, so fixed income can play a valuable role within a balanced portfolio to help reduce overall risk and provide diversification.”

The benefits of a mixed portfolio of stocks and bonds “have reasserted themselves”, Dover said, providing investors a better balance of risk and return.

Drawing insight from colleagues Josh Lohmeier, Franklin’s fixed income portfolio manager and Mark Lindbloom, the firm’s Western asset portfolio manager, Dover noted that ‘agency securities’ – effectively, US bonds – as well as low-default risk investment-grade credit “look quite appealing to us right now as allocation destinations, particularly for more risk-averse investors”.

The researchers flagged a number of opportunities for investors across the fixed income sector:

1. Investment-grade securities, they said, would provide an attractive ‘baby step’ from US Treasuries. “Default risk is low, they are generally very liquid, and investors can get a bit more interest spread,” it was argued.
2. Municipal bond fundamentals are strong and benefiting from ratings upgrades. “As municipal bonds are generally high quality, if the economy moves into a slower-growth environment, they should remain an attractive place to invest. And the muni market is very large with myriad characteristics.”
3. Agency mortgage-backed securities provide another higher-quality return stream. These investments were recognised as “generally very liquid, have little to no credit risk and have attractive valuations”. In addition, given rising interest rates, there has been a lack of new mortgages, either through production or refinancings.
4. High yield requires credit selectivity at this phase of the economic cycle. While yields are compelling, our managers saw reasons for caution and favour a lower allocation to high yield than in prior years.