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In an era of increased central bank action to combat inflation, fixed income investors face a new, more volatile reality. Against this backdrop, it is easy to understand why investors tend to focus on the higher yields on offer, as discussed recently in this publication. Yet by focusing so much on yield, investors run the risk of overpaying for income and underestimating the impact of price volatility. A process that considers not only the role of yield but also the contribution of price fluctuations to total returns can help smooth outcomes over time, and, in doing so, create a more resilient portfolio.
Such a total returns perspective — incorporating analysis of both income and potential price return — requires a more flexible approach and a deep understanding of the credit sectors and securities that are likely to benefit from capital appreciation relative to the downside risk they face.
In my view, correctly identifying opportunities that offer the best chance of participating in the upside while minimising exposure to downside risk requires a repeatable and robust framework, rooted in active management and research. At the heart of this framework, I prioritise something that some fixed income managers seem to take for granted: the power of bond maths.
Of course, any bond manager worth their salt has a robust understanding of bond maths. But placing it at the heart of an investment process, in our experience, helps to build portfolios with an attractive asymmetric return profile that have greater potential to deliver a more consistent investment experience and mitigate risk.
How does this work in practice? Specifically, as a team, we use the price and structure of a bond as the basis to calculate projected upside versus downside total return scenarios. A bond that our research suggests has potential upside of 15% but only 5% downside could represent a compelling payoff on a risk-adjusted basis.
We believe this approach has proven effective over time. Take two examples in recent years1.
The first was in the months just before the pandemic. We adjusted our exposure to reduce risk in late 2019 and then increased risk in early 2020. This allowed us to protect capital in the first instance and then significantly participate in the upside swing.
Our guiding light here was the maths. In December 2019, for example, spreads on US investment-grade (IG) corporate bonds collapsed to an unusually tight level of 50 basis points (bps)2. Our evaluation of the upside versus the downside led us to believe that in a stable interest-rate environment, the most we could expect to earn in an IG corporate position, should spreads collapse to zero, was 2% — based on 50 bps multiplied by a duration of four years. Yet our analysis also showed that should an equivalent event to a taper tantrum occur, with spreads potentially widening to 2%, we could lose 8%, based on 2% for four years.
As a result, going into 2020, with spreads tight relative to history, we opted for a defensive posture, selling almost all our US IG corporate bonds in favour of US Treasuries and cash. This gave us “dry powder” to deploy, and as spreads quickly widened in the wake of COVID, it made sense to boost exposure to those IG issuers with robust balance sheets, and to longer-maturity bonds with higher spread duration that could benefit, should spreads tighten again.
A second example of bond maths proving its worth was in 2022. At that time, despite rising recessionary fears, we saw opportunities for greater spread tightening, despite most investors being concerned about a bleaker economic picture.
During this period, we witnessed BBB and BB spread differentials converging. We used this as an opportunity to increase our holdings of BBB rated securities, as our process, with bond maths at its core, gave us faith that these were fundamentally resilient. This exposure enabled us to take advantage of widening BBB spreads, while limiting the expected downside. Meanwhile, the potential upside was in the high single digits to mid-teens should spreads stay stable or narrow as sentiment and/or the economic outlook improved.
In the current market environment, where price outcomes are unpredictable due to increased global central bank action and policy divergence, we believe active strategies able to optimise price return and capital preservation have an opportunity to thrive. In our view, a process that is repeatable, grounded in the fundamentals of fixed income and that, crucially, maintains flexibility to adjust portfolio allocations and sector exposures offers investors the best chance of success.
Ultimately, we believe investors striving to achieve a more attractive risk-adjusted return profile should focus on three elements of an effective fixed income allocation:
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1PAST PERFORMANCE DOES NOT PREDICT FUTURE RETURNS. AN INVESTMENT CAN LOSE VALUE.
2Connor uses internal research in the formulation of his rates, curve and spread views. Although the formulation of these views is entirely his, he does use macro, sector, and credit inputs within his process.
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