Managed Fund: navigating the bond landscape

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Following a very difficult 2022 and a period of treading water in 2023, the last five months have seen better performance from bond markets. Yields on global government bonds, BBB (medium credit quality) corporate bonds and emerging market local currency bonds have all fallen of late. Correspondingly, prices have risen, but yields are still high and attractive relative to much of the last 20 years. So, what will drive the outlook for bonds over the next three to five years and beyond?

Fixed income yields

Some investors might spend all their time until November discussing who will win the US election, but for us, the outcome is similar. We think both presidents would maintain a fiscally expansionist policy by implementing tax cuts and/or increasing government spending. Although there may be policy changes, which we will take account of, what we really care about is the multi-year trajectory of the US economy.

It is, therefore, much more interesting and important to consider the broad macroeconomic scenarios that might unfold over the next few years, and how bonds might fare in each of them. We are concentrating our thoughts on three scenarios:

1. Soft landing/no landing: growth remains OK and inflation continues to moderate

This is our core scenario. It would see a fairly benign macroeconomic outlook, which would allow central banks to cut rates, not in direct response to weaker growth, but because lower levels of realised inflation warrant lower rates.

Although much of this scenario is arguably priced into valuations, we think it is one in which developed market government bonds will still offer an appealing return of 5-7 per cent per annum as starting yields are high, especially when compared to the negative yields many developed market government bonds offered just a few years ago. The additional yield available from corporate bonds and emerging market government bonds is attractive in this scenario. Investing in these asset classes will help boost the yield from developed-market government bonds. The Managed Fund bond portfolio currently yields 6.5 per cent - for context, this compares to just 2.7 per cent as of the end of September 2019.

In this core scenario, bonds justify their position in the portfolio and offer a higher return and better hedging properties relative to cash. Having been underweight bonds in our asset allocation for five years, we are now back to our strategic weight of 20 per cent.

2. Hard landing: growth continues to slow and the economy tips into a recession

In this scenario, bonds are the best place to invest compared with equities, especially developed-market government bonds because they provide a safe haven. In the event of recession, even more rate cuts would be priced in causing bond yields to fall and prices to rise by 5-10 per cent, on top of a 5-7 per cent coupon.

Higher-quality corporates would also do well, and we are positioned for this. Most of the Managed Fund corporate bond portfolio is in investment-grade corporates with an average credit rating of BBB across all bond exposures.

Assuming the recession is not too deep, high-yield corporate bonds would see some weakness, but the better names would be resilient. This highlights the importance of good bond selection and not just investing passively across the index.

Emerging market bond yields would likely compress alongside developed market government yields, although not as strongly.

Overall, the bond portfolio would likely have a positive impact on returns and offer balance to the fund in what may be a tricky scenario for equities in the short run.

3. Inflation is sticky

Central bank policy easing is very dependent on inflation continuing to moderate. There is a possibility that inflation stays stubbornly above central bank targets. In this case, investors would likely lower their rate cut expectations and we could see all bond markets sell off. It is very unlikely that bond yields would rebound to peak levels – the nearly 5 per cent seen over the last year or two – but they might partially recover to near 4.5 per cent, or experience a 3-5 per cent decrease in price, thereby offsetting most of the income return.

This would not be nearly as painful as the rapid rate rises of 2022, but it would be a challenging environment for bonds and other assets in the Managed Fund, regardless of the robustness of its holdings.

Bonds in the Managed Fund

While we debate the likelihood of different economic scenarios to inform our process, much of our investment research is directed towards finding bonds that can do well across a range of environments. Enthusiasm for underlying holdings is a key driver of our asset allocation within fixed income and across the Managed Fund.

Our active approach means we often find attractively priced bonds that are underestimated by the market.

One example is Brightline East (B-rated, 14 per cent yield to maturity). This bond is part of the financing for the first private high-speed rail line in the US for many years. The line between Orlando and Miami is now fully open and passenger numbers are ramping up. Brightline East is focused on attracting ‘long-haul’ passengers travelling along the whole route, to and from Orlando airport. The brand-new trains and stations are an attractive alternative to a long drive or congested short-haul flight. We think the project will reach profitability in the next few years, leading to rating upgrades and strong double-digit returns for bondholders.

As fixed-income portfolio managers for the Managed Fund, it is our job to construct a bond portfolio that allows room for standout investments like Brightline East but also has steadier names to ensure diversification and resilience.

Conclusion

One-fifth of the Managed Fund is invested in fixed income, per our strategic asset allocation of 75 per cent equities, 20 per cent bonds, and 5 per cent cash. We expect the fund’s active equities to be the main driver of value creation in the long run. However, bonds play an important balancing role and can offer an attractive level of return in their own right, especially when active management unearths overlooked opportunities. Such opportunities place the fund in the best position for long-term capital growth.

Annual past performance to 30 June each year (net %)

Source: FE, Revolution, net of fees, total return in sterling. Class B Acc Shares.

Past performance is not a guide to future returns.

The manager believes an appropriate comparison for this Fund is the Investment Association Mixed Investment 40-85% Shares Sector median given the investment policy of the Fund and the approach taken by the manager when investing.

Important information and risk factors

This recording was produced and approved in October 2024 and has not been updated subsequently. It represents views held at the time and may not reflect current thinking.

The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.

This communication contains information on investments which does not constitute independent research. Accordingly, it is not subject to the protections afforded to independent research, and Baillie Gifford and its staff may have dealt in the investments concerned.

Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA). Baillie Gifford & Co Limited is an Authorised Corporate Director of OEICs.

Investment markets can go down as well as up and market conditions can change rapidly. The value of an investment in the Fund, and any income from it, can fall as well as rise and investors may not get back the amount invested.

The Fund’s share price can be volatile due to movements in the prices of the underlying holdings and the basis on which the Fund is priced.

Further details of the risks associated with investing in the Fund can be found in the Key Investor Information Document or the Prospectus, copies of which are available at bailliegifford.com.