- Fixed Income Portfolio Manager, Credit
Denmark, Institutional
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Investors are tackling a new regime globally that is forcing them to rethink their expectations of returns, and how they achieve them.
With central bank intervention increasing the frequency and magnitude of large moves in credit markets, the long-held assumption that returns from income allocations are generally less volatile no longer seems valid. In reality, the current landscape of higher and more magnified income and price volatility necessitates a more dynamic approach to meeting income objectives.
Put simply, we believe investors should look beyond yield by being more flexible. By allocating to US Treasuries for liquidity and diversification when needed, and then to corporate and emerging market (EM) debt when opportunities to generate income arise again, investors can potentially benefit from a more diversified and resilient portfolio. We do not think it is viable any longer to evaluate assets solely based on how much income could be earned by holding to maturity, but rather, to consider the broader potential of these investments.
Adapting to new regimes in economies and markets
Higher volatility is an inevitable consequence of scenarios around the world where governments are relying on fiscal policy to try to plug growth gaps – fiscal policy is doing the heavy lifting as monetary policy is a distant second.
While the fiscal impulse this year might be more muted than last, we see a high chance of running the type of historic deficit that has only truly been eclipsed in the post-WWII era amid crises like 2009 or the pandemic.
Meanwhile, a strong economy underpinned by fiscal support, solid employment and robust household balance sheets bodes well for markets. With healthy cash flows, corporates are less likely at current levels of yield to add leverage to their balance sheets. Yet, while credit-spread volatility should be substantially lower than interest-rate volatility, the opportunity is less compelling following the sharp credit spread rally at the end of 2023.
We believe this landscape is conducive for investors to maintain income but hold some cash. This is not due to fear of recession but to buy on dips, even if they are shallow. This should support risk for quite some time, and in the absence of what we consider to be any significant danger of a credit meltdown amid low levels of leverage, leaning overweight risk may prove rewarding.
Looking beyond yield
Possible dangers for investors against the backdrop of today’s environment are overpaying for income and underestimating price volatility
This is understandable – it is easy to get drawn in by the allure of yield alone. Given investors' desire for yield at any price, fixed income market pricing is often pushed to extremes inconsistent with fundamentals and reasonable expectations for forward-looking returns.
A case in point is the return breakdown from January 2021 to December 2023 of two commonly used market indices – the US Aggregate Index and the US Intermediate Credit Index. As the chart shows, the respectable income earned was eclipsed by the total return, which was negatively impacted by the price drawdown.
To avoid that type of situation, plus add required flexibility in portfolios, US Treasuries can be a true diversifier versus credit and risk and an effective source of liquidity.
More specifically, we believe higher allocations to US Treasuries make sense when credit spreads are tight to potentially support efforts to protect capital and insulate the portfolio from positions where negative price return could overwhelm income. US Treasuries can also enable investors to maintain dry powder to deploy when volatility creates attractive income and capital appreciation opportunities.
We also believe that consistent, positive total returns are more achievable if investors separate themselves from a benchmark and replace corporate credit risk with US Treasuries when corporate bonds are not compensating investors for underlying credit and liquidity risk.
Ultimately, fixed income investors can think of themselves as acting as liquidity providers during periods when large asset owners are forced to sell in times of robust demand with stretched valuations.
While it is common to chase yield, today’s macro and market environment calls for a more flexible and creative fixed income strategy. We believe the focus should be on maximising risk-adjusted total return over the long term with a simple yet dynamic and active approach to security selection that looks beyond benchmarks and shifts between Treasuries and corporate and EM debt to exploit pricing inefficiencies while generating income.
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