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Bonds set to soar with deflation

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High-quality Australian bonds have been singled out as an attractive investment option, promising both stability and appealing returns in 2024.

Investors should consider an allocation to high-quality domestic bonds in 2024 to capitalise on opportunities arising from expected interest rate cuts and a deflationary economic environment, according to an Australian investment firm.

Income Asset Management credit strategy and portfolio management executive director Matthew Macreadie pointed out expectations of an economic loosening in Australia led the firm to believe the time was ideal for bonds.

Macreadie said: “2024 promises to be a year of clear winners and losers where security selection will be rewarded. We expect to see some high-yield defaults impact the market, but overall the investment-grade credit market is likely to gain in strength.

“With inflation falling from its multi-decade highs and the prospect of modest rate cuts in the second half of 2024, we should see longer-duration, high-quality bonds perform well and gain in value.

“Beyond 2024, interest rates could fall further as central banks, having likely tamed inflation, reduce interest rates to protect employment and economic growth, supporting the environment for bonds.”

He further added economic movements in the United States should not be relied upon to give an accurate picture of how fixed income investments, particularly domestic corporate bonds, might perform over time.

“Australian credit spreads usually follow credit spreads in the US, but we believe they could outperform in a recessionary scenario. That’s because Australia’s real economic growth supports the credit environment and Australian investment-grade credit has historical default rates close to zero,” he said.

“In addition, Australian superannuation funds have been increasing their exposure to fixed income and Australian BBB investment-grade credit spreads are wider than equivalent US investment-grade credit spreads – so we are confident of the potential for the outperformance of high-grade Australian corporate bonds.”

He noted certain sectors are expected to perform better in the long run, particularly tier 2 bank and insurance bonds, which he described as providing higher-than-average returns considering the level of risk involved.

“Australian banks are well positioned for any downside in the economic outlook. They are well capitalised, with very high common equity tier 1 capital ratios. The most positive development has been that Australian mortgage delinquencies have not really risen significantly despite central bank tightening,” he said.

“Residential mortgage-backed securities (RMBS) are also favoured, given credit spreads effectively doubled in 2022 and are only now starting to normalise across senior and mezzanine tranches. From our perspective, buying AA-BBB-rated RMBS tranches at yields of 7 per cent to 9 per cent with strong collateral protection remains very attractive.”

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