Why fixed income, why now?

Read this article to understand:

• How fixed-income valuations are improving relative to recent years
• Why 2023 is likely to bring greater dispersion between strong and weak issuers
• Our asset allocation views

2022 was an awful year for financial markets. The S&P 500 posted its worst annual performance since 2008, just as global bonds fell into a bear market for the first time in 70 years.

The biggest driver of these trends was much stronger-than-expected inflation.  Russia’s invasion of Ukraine in February caused spikes in energy and food prices that hit all economies hard, particularly emerging markets. Central banks responded by embarking on their most aggressive monetary tightening cycle in a generation, with G10 countries delivering around 2,700 basis points of rate hikes in 2022.

Investors could be forgiven for remaining cautious on fixed income at the beginning of 2023 given the stern challenges still facing the global economy. Macro risks remain; central banks look set to continue hiking interest rates and inflation is still a threat.

But with yields rising – in some areas reaching highs not seen in a decade – bonds could offer attractive income to help cushion some of the market volatility. And this speaks to a broader point: after a prolonged period of low returns following the Global Financial Crisis (GFC), value is finally returning to the asset class.

Why fixed income?

To understand the new environment, we have to take a step back to look at how we arrived at this point.

Traditionally, investors sought bonds for three reasons: income, capital return and a negative correlation to riskier asset classes. But the fallout from the GFC distorted all three.

In the wake of the crisis, central banks slashed interest rates to spur economic activity. Bond yields plunged, in some cases into negative territory: the amount of negative-yielding debt in circulation globally peaked at a staggering $18 trillion in December 2020.¹

With income falling, capital return became the main source of bond returns, due in part to the successive quantitative easing (QE) programmes deployed by central banks as part of their stimulus efforts, which boosted asset prices (see Figure 1).

The post-GFC regime also had implications for the correlations between bonds and risk assets. One consequence of the low-yield environment was that it increased the sensitivity of bonds to interest rates – bond duration, a measure of this sensitivity, doubled between the early 1980s and 2021 – making them vulnerable to sudden rate hikes.²

This was dramatically illustrated in 2022, when inflation surged and central banks tightened policy in response. Returns on both debt and equities collapsed and correlations between the two asset classes significantly increased (see Figure 2).

This called into question the traditional portfolio allocation of 60 per cent to equities and 40 per cent to bonds, predicated on the assumption bond returns are negatively correlated to equities during periods of market turmoil, helping 60/40 portfolios preserve capital and dampen overall volatility.

Why now?

While it will go down as one of the most painful years on record for bonds, the upshot of all the pain dished out by central banks in 2022 is that the three key attractions of fixed income have been reset.

Start with income. In a world of higher interest rates, investors are finally being paid for holding bonds, with yields at levels not seen for almost ten years (see Figure 3).

Since 2009, the phrase “TINA” – an acronym that denotes There Is No Alternative (to owning equities) – has often been heard among the chatter on trading floors as loose monetary policy crowded investors out of fixed income into equities. But now, “TARA” (There Is A Real Alternative) may become the new watchword, given higher bond yields on offer relative to dividend yields (see Figure 4).

There is also potential for bond-equity correlations to revert to historical levels, and for bonds to resume their traditional role in dampening some of the portfolio volatility associated with equities.

When yields were low and central banks started raising rates, returns were always going to fall given the duration of the asset class. But with higher yields in play, there is now a “normal” two-way risk in bond prices. Stronger income should be able to offset some of the impact of rate hikes.

The global economy is expected to enter a mild recession in 2023 as growth slows and central bank policy remains tight. As more economies move towards recession, the need for further monetary tightening will diminish. This is why we believe we have likely seen the peak in rate acceleration. Even with signs of slowing inflation, the pace at which prices decline will be a key determinant of policy actions.

We do not profess to know exactly when the current hiking cycle will end, nor the extent to which global growth will slow over the course of 2023. What we do know, however, is that because fixed income valuations have significantly improved, they now offer investors more protection should global growth slow faster than expected or inflation remain stubbornly high.

Be careful what you wish for

Another key point to consider is that we are likely to see increased dispersion between securities in this new environment.

One of the many distorting effects of successive QE programmes was to suppress dispersion between issuers. But with central banks no longer acting as an indiscriminate buyer of government and corporate bonds, alongside a slowing global economy and higher interest rates, we expect higher spreads and a greater dispersion between fundamentally strong and weaker issuers. As shown in Figure 6, dispersion significantly increased between the end of 2021 and mid-January this year.

For active managers that rely on fundamental stock picking, the last decade has been challenging. The big macro calls, rather than bottom-up issuer selection, largely drove returns. The return of dispersion should be welcome, then – but investors should be careful what they wish for given the increased downside risks from getting security selection calls wrong. In our view, this environment will favour those with more fundamentally and risk-aware driven processes.

Fixed income asset allocation

Given the factors enumerated above, we believe there is scope for fixed-income assets to outperform once recovery is on the horizon and can be reasonably be priced in by the market. But there are nuances to consider within different asset classes.

Start with government bonds. The rapid repricing of hiking cycles across G10 countries have taken developed-market government bond yields to their highest levels since 2008. Risks are two-sided: if inflation is more entrenched, then despite economic weakness, monetary policy will have to remain restrictive. The upside scenario for sovereign bonds is that inflation either proves transitory or that a hard landing occurs, necessitating lower rates to cushion economic distress.

Government bonds arguably offer better value than they did a year ago. But we expect greater dispersion in total returns going forward, as central banks and financial markets remain on heightened alert for continued signs of persistently high inflation. Fiscal policy, issuance plans and quantitative tightening will also be in focus.

In this potentially volatile environment, a global approach to government bond allocation can help improve diversification and reduce exposure to idiosyncratic shocks (such as the spike in gilt yields prompted by the UK government’s “mini-budget” in September 2022).³

Emerging-market debt (EMD) arguably looks to be the most attractive part of fixed income currently, although it will still face headwinds in the early part of 2023.

EM local-currency government bond yields have risen from sub-six per cent at the beginning of the year to over seven per cent. Hard-currency spreads are 100 basis points above pre-pandemic levels and offer adequate protection when taking default and recovery rates into account.

The end of rate hikes will be the catalyst for the strong US dollar to stop inflicting losses. Just as importantly, the wide variation in valuations and fundamentals will continue to provide ample relative-value opportunities within both asset classes.⁴ As the emerging-market universe has grown to include more investment-grade bonds, in addition to high-yield debt, an allocation to EMD may benefit a broader multi-asset portfolio, offering yield enhancement and diversification benefits.

As for high yield, the recent rally in spreads has reduced the attractiveness of the asset class, especially given the uncertain economic outlook. However, set against this, high yield looks more resilient than during previous recessions.⁵ Our current expectation is that high-yield credit spreads will widen, but investors should see a stronger total return in 2023 because the all-in yield is essentially double this time last year. Similarly, the all-in yield on short-dated investment-grade paper makes it relatively attractive, but it is competing with strong risk-free cash returns.

Finally, we prefer to be long the US dollar, reflecting the weakening global growth environment and the strength of underlying inflation in the US. However, the longer-term dollar trend could eventually reverse as growth prospects improve later in the year.

All things considered, 2023 could herald the beginning of a new era in fixed income, characterised by higher yields and greater dispersion in returns than we have been accustomed to in the post-GFC period. Shrewd security selection and a fundamental-focused approach will be crucial for those hoping to capitalise on the opportunities.