Here’s what you need to look for when buying bonds in 2024

Another reason to buy bonds is typically their safe have status.

The timing of shock events and magnitude are rarely predictable, but the news flow in March provided another example of why insurance-like elements of duration are so important for a portfolio.

Despite inflation still being above 6 per cent, investors went diving for safe haven assets, as first US regional lender Silicon Valley Bank then Credit Suisse collapsed.

That sparked a sell-off in the sharemarket, sending the ASX 200 down 6.4 per cent, ASX REITs off 13 per cent, and the S&P 500 6.6 per cent lower. Australian 10-year government bonds jumped 0.80 per cent to 3.2 per cent (a 4.4 per cent return on the month), and high-grade non-sovereigns rallied solidly too.

Then there is the inflation (or disinflation) element.

Tension between tight labour markets and the uneven lags of earlier monetary policy changes on inflation have been reflected in the wide ranges in yields this year. But herein lies the opportunity for both passive and active investors.

The March upheaval contributed to markets focusing on weakening fast twitch activity data, thinking inflation would subside enough for the US Federal Reserve to start cutting rates before the end of the year.

But US cash rate efficacy is diminished because most mortgages have been fixed at very low rates for 30 years. With long bond yields markedly lower than cash rates and the lags in policy changes, US financial conditions weren’t as tight as the market implied.

Yield rise hits confidence

Oil prices also bottomed during June, averaging $US70.20 a barrel, only to jump  25 per cent in the next three months. With a three- to six-week lag, the price of petrol went up, adding to the cost of transporting goods including food, and eventually the CPI data.

Having averaged 3.90 per cent in August, 10-year US Treasuries also surged to hit 5 per cent in October. The Fed and other central banks reiterated their bias to lift rates further. And some did.

For investors, the accrual value of bonds was acknowledged, and the sharp rise in bond yields hit confidence that it was safe to increase bond duration. Some rationalised that the time to add duration was when central banks start cutting rates.

The shift higher in yields that shook investor confidence tightened financial conditions meaningfully and skewed the probability that the right time to add duration had begun.

Watch for a shift lower in inflation that central banks are likely to react to, given lower inflation should lead to lower bond yields (and therefore higher bond prices). History shows the lion’s share of the rally in bonds occurs before central banks start to cut rates.

If lower prices persist, along with lower wage expectations, then the price wage cycle may adjust lower.

For example, between June and December in 2014, oil prices plunged 54 per cent and the RBA restarted an easing cycle by cutting cash rates at the February 2015 meeting to 2.25 per cent. Ten-year bonds rallied by only 0.15 per cent to 2.30 per cent after the RBA easing; a 1.9 per cent return over the period.

They had already fallen 130 basis points from August 2014 to the February rate cut (a 12.7 per cent return) in reaction to the disinflation pulse that led to the monetary easing.

This has relevance today because as global activity has weakened, and extra supply has hit the market, oil prices have fallen 20.3 per cent since September. If sustained, this could contribute to a disinflationary pulse that turns central banks.

US Treasury yields have fallen about 50 basis points from the high October average yield; Australia a little more.

The lags between the fall in the global oil price to the petrol station to the CPI data probably means that disinflationary pulse may still have more to be priced into bond markets.

Indeed, if lower prices persist, along with lower wage expectations, then the price wage cycle may adjust lower.

This is not to diminish the importance of the rental inflation locally, and the current hawkish tone of the RBA, but it does recognise that global inflation and interest rates affect local markets.

So, accrual? Tick. Safe haven status? It is usually a tick. And the disinflationary pulse? There is a good chance of a tick for that too in 2024.

Chris Dickman is a senior portfolio manager at Altius Asset Management.