Partner Insight: Is it time to move to corporate bonds?

With interest rate cuts from central banks on the horizon, investors may want to consider moving some cash exposure to the natural first step: short dated high quality corporate bonds, says Ben Deane, Investment Director, Fixed Income - Fidelity International.

Sarka Halas
clock • 4 min read
Partner Insight: Is it time to move to corporate bonds?

Assets in money market funds are close to $6tn, having doubled from the asset level pre-pandemic, with Fidelity's money market funds seeing strong asset growth too. This makes sense, for investors used to almost zero rates for the decade following the Global Financial Crisis the prospect of >5% yields from low-risk cash investments was, and is, attractive.

There will always be a need for cash, particularly for those investors prioritising liquidity and capital preservation. However, some investors may be allocating to cash for the prospect of outperformance versus other asset classes. While this was the right call in recent years, those investors might want to consider corporate bonds looking ahead.

Interest rate cuts are just around the corner

The negative drivers of bond returns - inflation and interest rate hikes - are abating which sets fixed income up well for the period ahead. Inflation is moderating and central bankers are now talking about the timing of interest rate cuts.

Ahead of a cutting cycle cash rates are elevated because, like today, they tend to have followed a series of rate hikes which optically makes cash look attractive from a forward-looking return standpoint.

So, why bother with corporate bonds if you can get more-or-less the same level of yield from cash?

 Firstly, cash is more exposed to reinvestment risk. Reinvestment risk refers to the risk that investors are unable to reinvest cashflows, such as coupons or principal, at a rate comparable to the current rate of return. As rates fall, cash and money market instruments are more exposed to this risk given these securities often have maturities measured in days (rather than years). This means cash yields (and returns) more closely follow central bank rates lower relative to bonds.

On the flipside, fixed income securities have a fixed income for a longer period of time and the value of those cash flows rises as interest rates fall. This impact is known as duration risk, a measure of the sensitivity of the price of a debt instrument to a change in interest rates.

So, if central banks are due to cut rates, time to add as much duration as possible? Not quite, for two reasons. Firstly, markets tend to price in cuts before they happen and so the extent of the rally in bonds during a cutting cycle depends on how many cuts were already priced in. Secondly, if the yield curve is inverted, like today, then short dated bonds can outperform longer dated bonds as the curve normalises despite having less duration risk. In these unique circumstances your position on the curve can be a more powerful driver of return than the absolute level of duration. The curve inversion makes us particularly constructive on 1-5yr corporate bonds.

Finally, through active management, we can pick those bonds with a more attractive level of yield per unit of risk to generate an excess yield over cash and comparable indices.

For the risk averse investor looking to outperform cash in the medium term we think corporate bonds are set up well as the BoE starts to cut. Furthermore, with the yield curve inverted, 1-5yr corporate bonds may be an attractive option over 3yrs. Over the longer term (5yrs), all-maturity corporate bonds standout well as the curve normalises and investors can once again benefit from higher yields for taking more risk via longer dated bonds.  

To learn more about current opportunities in fixed income, enter your details to access the guide.

Important information

This information is for investment professionals only and should not be relied upon by private investors. The value of investments and the income from them can go down as well as up so the client may get back less than they invest. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates rise and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Due to the greater possibility of default, an investment in a corporate bond is generally less secure than an investment in government bonds. Fidelity's range of fixed income funds can use financial derivative instruments for investment purposes, which may expose them to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Investments should be made on the basis of the current prospectus, which is available along with the Key Investor Information Document (Key Information Document for Investment Trusts), current annual and semi-annual reports free of charge on request by calling 0800 368 1732. Issued by FIL Pensions Management, authorised and regulated by the Financial Conduct Authority. Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM0324/385981/SSO/NA

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