In recent years, fixed income investors struggled against low rates and a low-yield environment, but this backdrop has given way to a completely new landscape. Back in 2020, if you were an investor in government bonds, there was a fairly good chance you’d be receiving a negative yield – essentially paying to buy government debt, while even in better-yielding sectors total returns were challenged.
Last year, central banks implemented an enormous shift in monetary policy to control inflation, and we expect this trend to continue. Looking forward, investors can expect this new regime of higher inflation, increased volatility and more restrictive monetary policy will remain intact. Fast forward to 2023, and bonds benefit from higher rates and, in the case of credit, attractive spread levels.
This new environment creates real opportunities for long-term fixed income investors, particularly in the credit space — provided they can navigate it successfully.
The new macroeconomic regime we are entering will come with a new set of characteristics, all of which will affect how investors look at bonds. Higher and more volatile inflation and interest rates will shape the market backdrop.
Additionally, investors should expect restrictive monetary policy, increased dispersion, especially within credit, and further periods of positive correlation between bonds and equities to impact investments.
How should fixed income investors approach this regime shift?
The rulebook hasn’t been torn up, but in this environment, the rules for successful fixed income investing have been somewhat rewritten. Investors need to re-evaluate their approach to asset allocations and should consider the following fixed income themes:
- Rethink the role of bonds. More volatile inflation will challenge static or passive bond investing. More dynamic and diversified allocations may be appropriate. Investors should explore the full spectrum of fixed income, looking across government, the credit risk spectrum and securitised debt, which can give investors a better chance of attaining the important bond attributes of liquidity, yield and uncorrelated returns to equities.
- Turn volatility into a potential advantage. Given the likelihood of increased volatility and dispersion, success is likely to be more aligned with an active approach. Fixed income is more cyclical than is often assumed. Specifically, the removal of central bank support has reconfirmed the view that credit is a cyclical asset class, and that being nimble is key to navigating a quickly changing environment. Investors can expect huge dispersion in how individual credits will navigate the coming cycle.
- Access multiple perspectives. Success in the new environment will depend on an investor’s ability to identify relevant information. Access to multiple perspectives across a range of regions, specialties and lenses makes this more likely. Remember that issuers of credit also rely on public or private equity financing – investment managers with access to information from both sides of the capital structure may be able to make more informed investment decisions. Environmental, social and governance (ESG) factors can also have a significant impact on long-term performance, particularly as dispersion among investment-grade issuers increases.
- Keep a close eye on liquidity. Recent events in the UK have once again demonstrated the vital importance of ensuring fixed income portfolios have liquidity profiles that are appropriate for a more volatile market. Investors should keep an eye on the global liquidity cycle and should ensure that they able to actively manage their portfolios in a liquidity squeeze.
Investing under the new regime
With all of these elements in mind, the next 12 months are going to be interesting for bond markets. The continued removal of accommodative policy by central banks will accentuate those idiosyncratic risks at a time when companies are increasingly exhibiting late-cycle behaviour.
Although we do not expect a deep recession, we do not believe that central banks have conquered inflation. This means that there will probably be a longer but shallower recession to come and that bond yields may remain elevated, perhaps for longer than the market assumes.
As a result, credit returns may be healthy as corporates deleverage their balance sheets in a slow, but not catastrophic, economic environment. If rate surprises wrongfoot the market, then investors can expect further volatility – bringing with it opportunities for active managers to outperform.
Paul Skinner is fixed income investment director and Matt Knight is head of UK & Ireland distribution at Wellington Management. The views expressed above should not be taken as investment advice.