Bonds or equities: which asset class presents a better investment opportunity?

Bonds and equities often play different roles – equities are higher risk but can offer better returns, while bonds are usually seen as steady investments that can temper volatility in a diversified portfolio.

One of our core asset allocation decisions over the past 18 months has been to overweight fixed income and underweight equities. Despite equities performing well over the period, we believed bonds offered better risk-adjusted returns.

However, as credit market spreads remain at historic lows, and constantly shifting central bank expectations introduce volatility into sovereign bond markets, the argument about relative value versus equities must be revisited.

Investment grade (IG) and high yield (HY) bonds spreads tighten further

Corporate bonds have delivered respectable returns so far in 2024. High yield bonds have performed particularly well, generating equity-like returns with lower volatility. The iBoxx Global High Yield Hedged index has achieved a return of 12% over the last 12 months, while iBoxx Sterling Corporate Bonds generated returns of 7% over the same period. Source: Bloomberg, data as of 11 November 2024.

In recent months, credit spreads – the difference in yield between corporate bonds and comparable government bonds – have tightened to historically low levels. At the end of October, US high yield spreads were between 255-275bps which we consider to be too tight. Despite strong underlying data, any deterioration in macro fundamentals or an increase in defaults would not be compensated by current spreads levels.

Source: Bloomberg

As with high yield bonds, investment-grade (IG) bond spreads are also tight versus historical levels. However, company fundamentals remain strong so we think the asset class is mostly fairly priced.

Changes to Dynamic Asset Allocation (DAA)

In November’s asset allocation meeting, we made a series of changes to our positioning across different fixed income asset classes:

1. Fixed Income – downgraded from overweight to neutral
2. Corporate IG – downgraded from overweight to neutral
3. Corporate HY – downgraded from neutral to underweight

As discussed earlier, credit spreads are at historically tight levels and some parts of the market are not offering sufficient compensation for additional credit risk taken. For that reason, we have downgraded our investment grade position from Overweight to Neutral, and high yield from Neutral to Underweight.

It is important to note that this refers to broad IG and HY markets and funds that track market indices. We continue to see benefits of short-dated pan-European investment grade credit in our portfolios where already held.

We will also maintain allocation to actively managed benchmark agnostic high yield managers which are able to select good issues and look through the cycle.

In light of these downgrades and our unwillingness to increase duration risk at this time due to excess volatility, we have decided to downgrade fixed income at headline asset class level.

These changes reflect a reassessment of the risk-reward balance within fixed income as a standalone asset class. While fixed income investments still form a key part of a diversified portfolio, its relative appeal compared to equities has decreased.

Equities upgraded from underweight to neutral

Overall, we are adjusting our equity position from underweight to neutral, reflecting our views on the change in relative value compared to fixed income, rather than an increased attractiveness of equities as a broad asset class.

The equity market is currently experiencing significant dispersion in valuations and earnings expectations across different regions, market capitalisations, and sectors, presenting relative value opportunities.

Headline earnings expectations for the US market continue to be elevated due to increased optimism about large cap tech companies. This has set a high bar to clear for these companies increasing risks to valuations if earnings growth does not meet expectations. However, expectations for the rest of the US index seem to be more realistic. We see the recent broadening of the market rally across companies and sectors as a positive sign of falling exuberance.

Elsewhere we see relative value opportunities. UK mid caps and EU small caps are trading at historically low levels due to overly negative sentiment. We believe there is too much pessimism priced in making it much easier for these companies to outperform expectations.

Looking ahead, a significant shift in US policy direction will affect US and global macroeconomic dynamics. It will take time for these policies to be implemented and for their full impact to become clear. As a result, we anticipate structurally higher market volatility for equities as the policy landscape unfolds.

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