This Ugly-Duckling Asset Is Looking A Lot More Like A Swan

This Ugly-Duckling Asset Is Looking A Lot More Like A Swan
Russell Burns

about 1 year ago4 mins

  • Corporate bonds saw strong ETF inflows this month, after sagging for most of the year.

  • Investment bank Morgan Stanley sees high-grade corporate bonds outperforming equities through the first quarter of 2023

  • JPMorgan Asset Management thinks the 60/40 portfolio can once again form the bedrock for portfolios.

Corporate bonds saw strong ETF inflows this month, after sagging for most of the year.

Investment bank Morgan Stanley sees high-grade corporate bonds outperforming equities through the first quarter of 2023

JPMorgan Asset Management thinks the 60/40 portfolio can once again form the bedrock for portfolios.

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Major investment banks and fund managers say there’s one asset that’s starting to look more attractive than the rest. And recent ETF buying activity shows that retail investors are beginning to come to the same conclusion. And here’s the thing: with so many investors still ignoring this long-shunned asset, you can still buy it at some pretty good prices.

What’s this attractive asset?

Morgan Stanley, which spent much of the year favoring cash, now says high-grade corporate bonds, currently yielding 5%-7% across maturities, will outperform global equities, at least through the first quarter of 2023. And retail investors appear to agree: they moved $16 billion into US corporate bond ETFs in the first 23 days of this month, the most since July 2020, according to fund-flow tracker EPFR. They were buying up corporate bonds of all kinds, with high-grade bonds seeing net inflows of $8.6 billion in November, and riskier low-rated or "junk" corporate bonds even seeing net inflows – to the tune of $7.1 billion. That's a pretty notable rise for the junk category, which saw $55 billion in outflows in the first ten months of this year.

Right now, investing in bonds can still be considered a contrarian play – and that’s good. Going against consensus positioning can be a successful strategy and allow you to scoop up assets at a nicer price. As Morgan Stanley points out in its 2023 investment outlook, households are still overweight equities (blue line) and still underweight bonds (gold line).

Households are underweight bonds and overweight equities. Sources: Bloomberg and Morgan Stanley
Households are underweight bonds and overweight equities. Sources: Bloomberg and Morgan Stanley

What’s the ideal weight then?

While stocks are a great long-term investment, a portfolio of 100% in stocks doesn’t make for a very balanced portfolio. And it wouldn’t have worked out very well this year, with stocks down about 20%. With bonds now looking more attractive, both Morgan Stanley and JPMorgan Asset Management say the classic 60/40 portfolio – with 60% of a portfolio invested in stocks and 40% in bonds – is likely to offer attractive returns once again, after delivering its worst performance on record for much of this year. Morgan Stanley says you can expect to see the long-term expected return of the 60/40 portfolio back above its 20-year average.

Long-term expected returns for the 60/40 portfolio. Sources: Bloomberg and Morgan Stanley.
Long-term expected returns for the 60/40 portfolio. Sources: Bloomberg and Morgan Stanley.

JPMorgan, meanwhile, in its outlook for 2023, is forecasting that the classic strategy will provide an annualized return of 7.2% over the next ten to 15 years, a jump from 4.3% in 2021. With their yields now higher, bonds are again a plausible source of income and a potential safe haven.

What’s the opportunity here?

The primary value in bonds is, of course, in the yields they offer. And while we’ve seen strong inflows in corporate bond ETFs, government bonds are also offering attractive returns after this year’s selloff. If we see a deeper-than-expected recession, then government bonds will likely perform strongly, acting as a safe haven and a hedge against likely declines in stocks.

ETFs are normally the easiest way to get exposure to bonds, and there are tons of corporate bond ETFs out there.

The riskiest ones – the ones with the most similar profile to stocks – are high-yield corporate bonds. The iShares iBoxx High Yield Corporate Bond ETF (ticker: HYG; expense ratio: 0.45%) tracks US high-yield bonds. If you’re investing from the UK or Europe, you might opt instead for the Pimco Short-Term High Yield Bond Index UCITS ETF, (STHS LN; 0.6%) which removes the US dollar exchange rate risk.

As the recent ETF inflows show, investors have also been piling into high-grade US corporate bonds. For American investors, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD US; 0.14%) offers that exposure, and for European investors, there’s the iShares USD Corporate Bonds UCITS ETF ( LQDE; 0.2%). For UK-based investors, there’s also a currency-hedged version, the iShares USD Corporate Bonds UCITS ETF (LQGH LN; 0.25%).

For government bonds, there is a similarly wide array of ETFs. Shorter duration investments often produce less volatile returns, and for that, you could consider the iShares 7-10 Year Treasury Bond ETF (IEF; 0.15%) or even the slightly higher octane iShares 20+ Year Treasury Bond ETF (TLT; 0.15%). Similar to corporate bond ETFs, there are currency-hedged versions that remove foreign exchange risks for non-US investors. For example, a UK-pound investor may prefer the iShares 7-10 Year Treasury Bond UCITS ETF (IGTM LN; 0.1%) or the iShares 20+ Year Treasury Bond UCITS ETF (IDTG LN; 0.10%).

If you’d like to own a 60/40 portfolio as all or part of your investments, the low-cost provider Vanguard offers a 60/40 tailored portfolio for both US and UK investors. For US investors, it’s the Vanguard 60% Stock/40% Bond Portfolio (VANSP60 US; 0.15%), while in the UK, it’s the LifeStrategy 60% Equity Fund (VGLS60A; 0.22%). That’ll get you the equity and bond mix at a cheap price, which could pay off if Morgan Stanley and JPMorgan are right about those above-average returns.

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