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Higher inflation, faster economic cycles, economic uncertainty: it’s not surprising that central banks around the world are struggling to set interest-rate policy with conviction. This has a knock-on effect for fixed income investors in the form of increased volatility — and we expect this to continue. At the same time, yields remain elevated even as central banks begin to cut rates, meaning that bonds are today able to offer both income and capital appreciation contrary to what occurred in the decade preceding today’s new economic era.
In this hard-to-navigate environment, how can bond investors continue to elevate their investments and balance opportunities and risks? We think there are three key things to bear in mind.
An increase in volatility can see a bond’s value fluctuate depending on its specific characteristics. Like any other type of volatility, this can present opportunities but also risks for investors.
When volatility was low, bond investing was simpler. Starting yields of bonds were a fairly reliable indicator of expected returns. Investors could decide the level of returns they needed in their portfolio and then look for bonds with starting yields that matched those expectations. However, they also understood that higher yields usually meant higher risk and more uncertainty about achieving those yields.
When volatility is higher, however, the path ahead can look quite different — both for higher-quality as well as lower-quality bonds — and realised returns can be meaningfully different from starting yields.
We think this is a particularly important consideration in the new economic era in which we find ourselves, where inflation, cyclicality and volatility are expected to remain higher than before. As Figure 1 illustrates, since 2011, more than 70% of the periods of higher-than-average credit volatility have occurred between 2020 and August 2024. We expect volatility to remain elevated.
Figure 1
Periods of higher volatility make bond investing less straightforward, but they can also create opportunities for investors — provided they are in the position to make the right decisions quickly. If bond investing during periods of low volatility resembled a relatively straightforward path, investing in fixed income during periods of higher volatility can look more like an endless set of crossroads, as new situations and questions arise. Where are we in the default cycle? What about the credit cycle? What happens if central banks cut interest rates further? What happens if they don’t? All of these questions lead us to one ultimate quandary to resolve: “given the set of opportunities and risks I see, am I attractively positioned for the next crossroad ahead?”
Choosing to stick with one area of the bond market — such as a static allocation to investment-grade credit — can work, depending on market conditions, and for many investors it has worked well in periods of low volatility. But it can also close investors off to the opportunities that may lie elsewhere. Having the ability to adjust allocations in response to differing market conditions — to take the wheel through making dynamic positioning decisions — creates potential opportunity for investors.
Comparing the relative performance of the most liquid safe-haven asset, US Treasuries and credit in different periods can help illustrate the potential benefits of flexibility. High-yield bonds have sparked interest due to the potential for investors to capture attractive all-in yields, so we have chosen to examine the relative performance of US Treasuries and US high-yield bonds. Figure 2 shows that there are times when Treasuries have outperformed high-yield bonds and times when the reverse is true. An investor who had chosen a static allocation to high-yield bonds may have benefited in certain scenarios. However, they would have missed the opportunity to take advantage of periods where Treasuries outperformed — and would have been exposed to downside risk, most notably around the time of the global financial crisis (GFC) in 2008/2009.
Figure 2
Arguably, the GFC was an exceptional period, but Treasuries were also the better exposure to have during other bouts of risk aversion. This supports our belief that a dynamic approach, where a manager has the flexibility and skill to assess the relative attractiveness of different areas of the bond market, can add value to portfolios in times of higher volatility. Simply put, being at the wheel can create greater potential for investors to harvest opportunities while avoiding unnecessary risks. We think a dynamic approach may be particularly relevant for today’s new economic era given its hallmark features of higher inflation, cyclicality and volatility.
We believe being at the wheel has applications beyond just making broader allocation decisions between different types of bonds and credit sectors. It can also extend across industry sectors and individual issuers. This means that an active portfolio manager can leverage credit and other types of fundamental research to uncover opportunities and risks at a more granular level. For instance, while a broad allocation to a sector such as utilities might seem straightforward, a deeper dive into regional and issuer-specific factors can reveal further and more nuanced insights. Credit research can help a manager anticipate issues and identify potential winners and losers within the sector. In an environment where structural factors are driving growing divergence, we expect those regional and idiosyncratic considerations to become increasingly important. By focusing on high-quality names and leveraging fundamental research, investors can aim to navigate the sector’s challenges and capitalise on opportunities as they arise while avoiding the issuers with the greatest challenges.
As volatility becomes the norm, bond investors must recognise that starting yields may not reliably predict returns. A dynamic approach, which allows for quick adjustments in response to market shifts, may potentially offer significant advantages over static allocations. This flexibility, combined with thorough credit analysis, enables investors to uncover opportunities and mitigate risks at both the sector and issuer levels. By staying at the wheel, investors can better position themselves to make the most of income and capital appreciation opportunities while managing the inherent risks in today's economic environment.
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