Potential of fixed income instruments in 2023
How do these instruments work?
In the financial world, fixed income instruments are traditionally understood as securities that provide two types of income : fixed and variable. These can be bank deposits, corporate/government bonds, tokenized fixed income assets, depository receipts, or P2P lending.
Usually, the fixed part is the interest rate of return on the security, periodically paid to the investor from the size of the par value of the security. The rate can be constant or floating, depending on the conditions of its issuer. The variable part is the nominal value of the security, which is estimated by investors in terms of their supply and demand and depends on many factors.
Together, the change in the par value of such a security and the value of the interest rate give the full rate of the instrument return. It is important to note that there are cases when the nominal value of a security falls and its interest rate rises to compensate for the yield, or vice versa. Therefore, the total return of such an asset is not very volatile, which is why the investment risks are lower.
The interest rate of such instruments depends on many factors. For example:
- Level of risk
Higher risk instruments such as corporate bonds or P2P lending typically offer higher interest rates than government bonds or bank deposits.
- The policy of the Central Bank
Usually, the higher key rate of the Central Bank (due to high inflation and overheating of the economy) means higher profitability, although there are exceptions.
- Tax Policy
Tax incentives for fixed income instruments can increase the popularity of these instruments and reduce the interest rate.
- Duration of the instrument
Longer terms usually carry a high interest rate. The risks to the investor increases with the length of time the fixed income security is held.
- Demand level
If investors want to buy more fixed income instruments than are available, the nominal price will rise. In this case, the fixed rate of return will proportionally decrease due to the growth of the financial burden on the issuer, and vice versa.
If one of the securities of one asset class rises in returns to levels above the market, one can expect an increase in returns for similar instruments in the short term, and vice versa.
In general, financial assets of this kind are used to minimize portfolio risk as part of choosing an investment strategy, and can also be considered as some kind of “support” for portfolio yield, compensating for losses on high-risk assets (stocks, futures, options, etc.)
However, the possibility of high risk has not bypassed this asset class. For example, a bank deposit initially assumes compensation for inflation, i.e., the interest rate is as close as possible to the annual rate of price growth in the country. Further, government bonds have a slightly higher yield than a bank deposit, as well as risk, because banks are considered more stable institutions than the state apparatus. At the same time, P2P lending has even greater profitability and risk than the same corporate bonds (although not always), because they are investments in loans from private legal entities or individuals.
To talk about the prospects for 2023, it is first worth looking at the historical dynamics based on open data sources.
Let's assume that we are comparing total returns on, for example, P2P lending in Europe, government and corporate bonds, and bank deposits in Europe. To do this, we need to consider the dynamics of the yield rate of the European P2P lending market, the global bond yield index (Bloomberg Global Aggregate Total Return Index, BGATRI), as well as the deposit rate in the Eurozone.
What do we see from these data?
- Deposit rates, expressed in terms of key rates, began to rise only in the second half of 2022, which is rather strange, given the start of rapid inflation since mid-2020.
- The current P2P market average rate of return (10.5%) has exceeded the average for the last 4 years (10.4%), which tells us that the market is gradually recovering.
- The BGATRI bond index also began to grow in the second half of 2022 after the growth of the key rates of the Central Bank, which confirms the theoretical aspects of the monetary policy of the Central Bank. Until 2H22, CBR rates were close to zero, which, in a sense, subjected the BGATRI index to either a random flow or other implicit factors.
- It is noticeable that average P2P rates increased as the key rates of the Central Bank grew. However, there is no theoretically substantiated connection here. Most likely, this is a reaction to the growth of profitability in assets that are competitive for P2P with a lower amount of risk.
So what could be the return on fixed income investment instruments in 2023?
In fact, this is a very complex process and a set of calculations to study the interaction of variables that affect profitability.
We can try to make a forecast for inflation, and then start from the previously described relationships. However, this is also not so easy to implement.
Among the main drivers of inflation are:
- demand-pull inflation,
- сost-push inflation,
- exchange rate fluctuations,
- rise in commodity prices,
- labor costs,
- government spending,
- low interest rates of the Central Bank,
- disruptions in supply chains,
- technological innovation,
- consumer expectations.
All this has a complex effect on inflation and creates difficulties for calculations.
Taking into account all the above factors, we expect the following dynamics in fixed income instruments in 2023.
What do we see from these forecasts?
- Due to lower yields on bonds and bank deposits, the average rate of the P2P lending market in Europe in 2023 may reach 12.6% (the levels of 2017-2018).
- Deposit rates directly depend on the key rate of the Central Bank, which makes them, of course, a low-risk asset, but potentially less profitable compared to P2P.
- The same applies to bonds, which could lose their competition with P2P, at least in Europe.
In fact, the main driver for all investment assets is inflation. It is targeted by the Central Bank, which, with the help of its monetary policy instruments, tries to control it. If inflation rises, then the key rate of the Central Bank automatically rises. After that interest rates on deposits / bonds begin to rise, which creates competition for high-risk assets that respond to this with the same increase in profitability (not always).
- Investment return is an oscillatory system, the momentum for which sets the rate of inflation. It “swings” the yield until the system again assumes a state of balance due to competition between assets.
- In the current global economic environment, European P2P lending looks the most promising in 2023. It is actively striving to become a leader in its fixed income asset class.
- The higher the return, the higher the risk. The final word is yours. When drawing up your investment strategy, you need to consider what risks you are willing to take for the sake of greater profits.
* - data taken from the P2P blog “TodoCrowdlending”
** - up-to-date data can be found on the Bloomberg website
*** - data taken from the Eurostat website and Investing.com