Equity-like returns and a favourable outlook ahead: now is the time for bonds

PIMCO's Robert Mead indicates that core bonds delivered equity-like returns of 8-9% last financial year, primarily driven by high starting yields that already price in anticipated supply. He asserts that with inflation now controlled and central banks initiating an easing cycle, the bond market's outlook is favorable, and the negative correlation between bonds and equities is re-establishing for diversification benefits. Mead also identifies opportunities for active managers to generate alpha by navigating global trade fragmentation and considering non-US markets for potentially better real returns.

Analysis

The fixed income market, particularly core bonds, presents a compelling opportunity characterized by equity-like returns and a favorable forward outlook. Recent performance, with core bonds returning between 8% and 9% in the last financial year, is primarily attributed to high starting yields, which PIMCO's Robert Mead notes explain approximately 95% of expected returns. The significant repricing in the rates market, exemplified by the US 30-year yield moving from 1.5% to 5% post-pandemic, has already factored in concerns over large fiscal deficits, such as the $37 trillion US deficit, and anticipated bond supply. The macroeconomic backdrop is supportive, with inflation viewed as under control and most central banks entering an easing cycle. This environment is also restoring the traditional diversification benefits of bonds; as inflation moderates, the low correlation between bonds and equities is re-establishing, making fixed income an effective portfolio diversifier again. Furthermore, ongoing trade policy fragmentation, while a source of volatility, creates distinct alpha-generation opportunities for active managers who can navigate the relative value between countries, as tariffs are inflationary for the implementer and deflationary for others. A suggested strategy involves positioning in the five-to-seven-year part of the yield curve to capitalize on central bank cuts and generate capital gains through roll-down.

Key Decisions for Investors

• Investors should consider increasing allocations to core bonds to capitalize on historically high starting yields and the favorable return outlook as central banks enter an easing cycle.
• Active managers can seek to generate alpha by exploiting dislocations from global trade fragmentation, potentially favoring non-US markets for superior real returns and positioning in the intermediate part of the yield curve.
• Utilize bonds to restore portfolio diversification, as the low correlation with equities is re-emerging with moderating inflation, but remain mindful that large sovereign deficits may constrain future fiscal responses, placing a greater burden on monetary policy.