A new path for bond investing

Today, fixed income investors have to operate in a very different environment with profound implications for how fixed income and, in particular, credit portfolios are managed.

How has the landscape for fixed income markets changed? 

Paul: The low-rate, low-yield environment of recent years has given way to a completely new landscape for fixed income. 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. Fast forward to 2023, and bonds benefit from higher rates and, in the case of credit, attractive spread levels. 

Last year saw central banks implement an enormous shift in monetary policy to control inflation, and we expect this trend to continue. Looking forward, we think that this new regime of higher inflation, increased volatility and more restrictive monetary policy will remain intact. 

This new environment creates real opportunities for long-term fixed income investors, particularly in the credit space — provided they can navigate it successfully as, compared to the last decade, this is unfamiliar terrain. 

What do fixed income investors need to consider in this new environment? 

Paul: The new macroeconomic regime we are entering into will come with a new set of characteristics, all of which will affect how we look at bonds. Our macro team expects higher and more volatile inflation, greater interest-rate volatility, more restrictive monetary policy, increased dispersion, especially within credit, and further periods of positive correlation between bonds and equities. Those are a lot of opportunities — and risks — to navigate.

How should fixed income investors approach this regime shift? 

Paul: The rulebook hasn’t been torn up, but in this environment, we think the considerations for successful fixed income investing have been somewhat rewritten. 

1. Rethink the role of bonds. More volatile inflation will challenge static or passive bond investing. More dynamic and diversified allocations may be appropriate. Considering the full spectrum of fixed income, looking across government, the credit-risk spectrum and securitised debt can give investors a better chance of attaining the important bond attributes of liquidity, yield and uncorrelated returns to equities. 
   
2. Turn volatility into a potential advantage. Given the likelihood of increased volatility and dispersion, we think success will 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 our view that credit is a cyclical asset class, and that being nimble is key to navigating a quickly changing environment. We expect huge dispersion in how individual credits will navigate the coming cycle. 
   
3. 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, specialities, and lenses — makes this more likely. Remember that issuers of credit also rely on public or private equity financing — as a manager of both equity and fixed income, we believe an investment manager with access to information from both sides of the capital structure may be able to make more informed investment decisions. We also believe ESG factors can have a significant impact on long-term performance, particularly as dispersion among investment-grade issuers increases. 
   
4. 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. 

What should investors look out for over the next 12 months? 

Paul: The coming year is going to be interesting for bond markets. We do not expect a deep recession, but we do not believe that central banks have conquered inflation. This means we probably have 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, we expect further volatility — bringing with it opportunities for active managers to outperform.

How are we evolving our platform to meet the needs of investors in the new environment?

Matt: We believe it’s important that investors have access to broad expertise across the fixed income spectrum. As a firm, we have been managing fixed income since 1928 across several cycles, and since then we have built a robust platform of offerings over time, with dedicated investment teams focused on investment-grade and high-yield spaces. A common hallmark across all our strategies is the conviction that an active approach underpinned by fundamental research is key to driving the potential for outperformance over time. 

We think this approach lends itself particularly well to the current environment. Greater dispersion, increased interest-rate volatility, more differentiation between countries — these represent exciting opportunities for active fixed income investors — but deep research and access to a broad range of regional and sector expertise makes outperformance far more likely, in our view. Our fixed income teams operate independently, enabling them to be true to their investment philosophy and process, but they greatly benefit from our collaborative culture to gain the multiple perspectives we think are so essential in this new regime, whether that’s insights from their equity peers or analysis from our macro or geopolitical strategists.

Liquidity also remains a critical focus in this more constrained world. We pride ourselves in managing highly liquid portfolios and understand the importance of being able to deliver clients daily liquidity when they need it most.

What part does sustainability play in fixed income?

Matt: We think careful consideration of ESG factors is now on a par with fundamental credit analysis in identifying risks and opportunities at both a sector and company level.

ESG factors can have a significant impact on long-term company performance, particularly as the dispersion among investment-grade issuers increases. Growing ESG-related risks in areas such as climate change or supply-chain issues — together with quickly evolving regulations — create further impetus for well-performing companies to progress their sustainability practices. This accelerating momentum has only increased the importance of identifying likely ESG “winners” and “losers”. 

We have two really important climate partnerships with two of the world’s leading institutions in their respective areas of climate change: Woodwell Climate Research Center and Massachusetts Institute of Technology. For our fixed income investors, taking a long-term view, they need to know how climate is going to change, what the physical and transition risks are and how we can help guide them through a sensible transition. The research partnerships that we have with Woodwell and MIT are key to that scientific analysis.