Fixed income has been ushered into a new paradigm, precipitated by rapid increases in interest rates as major central banks look to tame stubbornly high core inflation. After years of ultra-loose fiscal and monetary policy, what is clear today is that higher rates will likely be more than a transient feature of the new environment.
While the process of getting to higher rates has been painful, particularly for holders of long-duration and rate-sensitive bond instruments, the way forward looks brighter. Yields are the highest they have been in many years and the diminished likelihood of further hawkish central bank activity should be supportive of bond prices. To successfully navigate the current environment, investors must tamper optimism with caution — the lessons of diversification, patience and active management are as relevant today as they were in the era of miniscule yields.
Diversification remains key
The US Federal Reserve (Fed) has increased interest rates from 0.25% to 5.50% since March 2022, the European Central Bank has hiked rates to 4% since July 2022 and the Bank of England has lifted rates from 0.25% to 5.25% since the start of 2022.
With cash yields at their highest in decades, investors naturally gravitated towards short-term instruments such as money markets and certificates of deposit. However, for investors with a long-term horizon, reinvestment risk — the risk that future cash flows are invested at lower prevailing rates – means today’s returns on cash cannot simply be extrapolated into the future. Finding strategic and diversified income sources can help minimise reinvestment risk and maximise risk-adjusted returns over a market cycle.
For example, with yield curves inverted in the US and Europe, creating short-term rates and higher than longer term maturities, investors may seek diversified sources of yields on the long end in emerging market (EM) fixed income. Inflation is decelerating at a faster pace in several EM economies relative to their developed market counterparts. Policy tightening appears to have reached a crescendo in many countries, with several central banks —particularly in Latin America and emerging Europe —already easing as economic activity slows. These markets offer high real yields, potential for total return and in the case of commodity net exporters, a possible hedge against rising inflation driven by high commodity prices.
The likelihood and severity of a global recession has been the subject of intense debate among market participants. Despite recent optimism over the Fed’s ability to engineer a soft landing, our view is that a recession in the world’s largest economy, should it occur, would likely have an outsized impact on corporate borrowers, as opposed to the US consumer. This partially informs our preference for mortgage-backed securities, particularly mortgage credit over corporate bonds. Housing fundamentals are buoyed by continued house price appreciation while existing homeowners are locked into low payments post-covid, creating a positive environment for the performance of these instruments on a risk-adjusted basis.
There are several other levers that a manager can pull to successfully navigate the new fixed income market, in pursuit of attractive risk-adjusted performance. Since the performance of fixed income sectors can vary meaningfully in different conditions, a focus on diversified sources of income and risk can positively influence long-term investment outcomes.
Patience remains a virtue
In challenging markets, investors may be tempted to seek refuge in unproven strategies that may seem appealing at the time or to try timing the ebb and flow of markets. Previous market cycles, however, demonstrate the benefits of patience and having a long-term mindset.
For instance, in the US, bonds have historically generated strong returns, on average, immediately following the end of Fed hikes. While we advocate a balanced and flexible approach, the virtue of staying invested over a cycle and having a long-term investment horizon hold true, regardless of style or approach.
Remain active
Active management across asset classes will remain an important tool for navigating the new fixed income market. With interest rates, elevated core inflation and geopolitical tensions creating market uncertainty, employing a disciplined approach based on the tenets of deep credit research, prudent portfolio management and robust risk management should prove valuable to investors.
Partnering with an investment manager that has a credible track record of managing flexible bond portfolios over a market cycle is one way of repeating the benefits of active management across fixed income sectors.
New market, same lessons
In an ever-changing investing landscape, investors that keep in mind the lessons of previous cycles should be well-placed to navigate new markets. Partnering with a fixed income manager with breadth and expertise across fixed income sectors and a proven track record of navigating challenging markets employing a flexible yet rigorous approach can create resilient investment solutions for all stages of the economic cycle.
Past performance is no guarantee of future results. All investments carry a certain degree of risk, including the possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time. Certain products and services may not be available to all entities or persons. There is no guarantee that a strategy’s investment objectives will be achieved.
