Spread the risk: Our top three fixed income diversifiers for 2023

Part I of this two-part series highlighted our five best credit market ideas for 2023. For Part II, we’ve identified three types of strategies that we believe are well positioned to provide fixed income portfolio diversification, while also generating potentially attractive income in a risk-controlled manner.

1. Macro-based rates and FX strategies

The 2022 macro and market narrative was driven largely by persistently higher inflation, forcing the major global central banks to move their policy interest rates into more restrictive territory. Many fixed income assets delivered negative returns against this backdrop, which in turn made many allocators realize that their bond portfolios lacked adequate risk diversification. 

One big takeaway, in our view: Having some exposure to absolute return strategies in rates and currencies (FX), which aim to earn positive total returns in any macro environment, may be critical to navigating the years ahead. Such strategies can seek to capitalize on bouts of macro and market volatility, as well as on potentially sharper differences between less synchronized global economies going forward. 

We believe the elevated market volatility will continue into 2023, resulting in increased dispersion within asset classes and greater differentiation among countries and companies. All of this should translate to a heightened need for investors to have flexibility and true diversification in their allocations, including the ability to adapt to changing market conditions and exploit dislocations as they arise. Maintaining sufficient portfolio liquidity may be particularly important to be able to respond appropriately to market peaks and troughs before it’s too late. 

Macro-based absolute return strategies could prove quite valuable in that regard and in providing a measure of portfolio stability as markets grapple with central banks evolving from volatility suppressors to likely sources of volatility. These strategies, depending on implementation, can complement an investor’s traditional core bond and US Treasury fixed income allocations. 

2. Core bond/core bond-plus strategies

Given the slowdown already occurring in some sectors of the global economy, it may make sense to consider core fixed income strategies in 2023, especially as rate-tightening cycles mature. The sell-off in US dollar rates last year, a decelerating pace of inflation, rising geopolitical risks, and the looming threat of a global recession all make high-quality fixed income assets look more appealing these days, in our judgment.

High-quality fixed income has traditionally played a pivotal role in overall portfolio diversification by supplying both interest-rate duration and reliable income. Duration acts as a potential counterweight to other portfolio assets; for example, episodes of investor risk aversion that may negatively impact equities often see high-quality bond prices rise. The income, meanwhile, can add some resilience to these bonds’ total returns, even as credit spreads fluctuate. 

The stubbornly low-rate environment of recent years imposed opportunity costs on investors for holding higher-quality bonds versus riskier, better-returning assets. With bond yields now up meaningfully, that opportunity cost has diminished. As such, we believe now is a good time to revisit the key role that high-quality credit can serve in a diversified fixed income portfolio. And remember, a higher-quality bond with positive convexity gains more value as rates fall than it loses as rates rise. The investor may take on more duration risk but typically enjoys greater capital appreciation during “flight-to-safety” periods, while also mitigating reinvestment risk in case of substantially lower rates. This feature is a foundational reason to own high-quality fixed income.

3. Short-duration bond strategies

To some investors, it may seem counterintuitive to own both core/core-plus fixed income and a short-duration bond strategy. However, we believe short duration has a place in many fixed income allocations, especially amid lingering uncertainty around US Federal Reserve (Fed) policy in 2023. 

The Fed’s 2022 rate-tightening campaign was rapid and aggressive, raising the federal funds rate by 4.25% over the full year — and with additional hikes likely this year. While the Fed’s more hawkish policy led to significant market volatility and asset price declines, one segment of the market benefited: short-duration fixed income. Cash equivalents and short-term bonds are now yielding more than at any time since before the 2008 global financial crisis. Given the inverted shape of the yield curve, rates are also magnified at the front end of the curve and offer attractive carry per unit of duration. Moreover, by virtue of their shorter maturity periods, short-duration holdings offer investors optionality to redeploy the cash that becomes available into other, potentially more compelling market opportunities.

A final consideration: Futures markets are currently pricing in a more benign Fed policy outcome than the Fed’s own forward guidance suggests. If the Fed does push (and keep) rates higher than many observers expect, then short-duration investing may enable investors to take advantage of the differential between dovish market pricing and the Fed’s more hawkish actions.

Related content

• Take credit: Our five best credit market ideas for 2023 (January 2023)
• Hidden in plain sight: Overlooked opportunities in investment-grade credit (December 2022)
• 2023 Macro and rates outlook: Goodbye easy money, hello regime change (November 2022)
• Fixed Income Outlook 2023: New landscape for bond investors in the year ahead (November 2022)