- Investment Director
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Key points
- We believe a diversified bond allocation can again act as a portfolio stabiliser.
- Embracing a global approach and exploring emerging markets (EM) opportunities can offer better risk/return potential.
- Impact bonds may offer a relatively uncharted source of both returns and portfolio diversification.
The new economic era of higher inflation, increased volatility and greater differentiation between countries, sectors and issuers requires a nuanced approach to constructing well-diversified bond portfolios. It also requires that investors question assumptions such as the below.
Fixed income used to provide portfolio stability but 2022 changed all that. Have bonds just become another source of volatility?
2022 and 2023 were particularly challenging years for bond investors, but they make more sense when you consider them as the ending point to a 40-year bull run in fixed income. We believe the unusual period wasn’t the sell-off in 2022 but the period between 2008 and 2022, when bond yields ground lower and lower amid central bank efforts to stem deflation.
With the return of inflation, bonds have regained their historic role in portfolios and now once again offer a stable source of income alongside downside protection and diversification benefits. Despite weaker performance in the face of rapid rate hikes, bonds have proved to be a strong source of portfolio diversification over the long term.
Furthermore, while defaults have been inching up since 2022, when higher interest rates started to feed through into higher borrowing costs for companies, this has caused companies less pain than many investors expected. As a result, we think default rates are likely to peak much lower than they have in previous central bank tightening cycles, and we see no obvious reason why a significant default cycle should be triggered, given robust corporate balance sheets.
With attractive yields in Europe, is there any need for European investors to go global?
This new macroeconomic regime will likely present shorter and more pronounced cycles and a greater occurrence of idiosyncratic risk — whether from country, sector or individual issuer. Amid growing divergence in economic performance and monetary policy, we believe going global can help investors to access opportunities across an inconsistent global policy landscape, as well as offer the potential to benefit from ongoing volatility, rather than avoid it.
It is also worth noting that certain subsets of the fixed income universe can become very concentrated if implemented in EUR alone, meaning that diversification becomes even more important to help increase the potential for alpha and reduce concentration risk. Figure 1 shows the merits of global diversification in credit given the varied sector composition of the USD, EUR and GBP corporate credit markets. As well as giving investors access to a much bigger pool of capital, a global approach also reduces the risk of being overly concentrated in one sector. Notably, financials represent a much bigger share of the GBP and EUR markets. An active investor can take this diversification a level further down to individual issuer exposures.
Figure 1
Regional diversification may offer further potential benefits within high yield. In particular, we believe that the European high-yield market offers higher quality relative to the US. This higher quality currently comes with more attractive valuations, which reflects the higher economic uncertainty but also offers significant opportunities for active management and strong fundamental analysis, which is crucial to separate winners from losers.
Above all, in an uncertain market landscape, we believe a flexible and nimble approach is key. Dynamic rotation across a broad opportunity set of fixed income sectors offers the potential to generate higher risk-adjusted returns with lower volatility than equities.
EM debt looks appealing but is it too volatile?
EM debt can be an attractive return driver and strong diversifier, especially from the perspective of a developed-market investor, but also shows cyclicality and periods of higher volatility. Right now, we see more opportunities than risks. In recent, more challenging years, EMs have proven to be resilient in the face of adverse macroeconomic conditions. After many EM countries hiked rates aggressively in response to rising inflation, local rates remain high for most countries — still in double-digit terrain for some, having much more room to ease rates than developed countries. We have seen the first EM rate cuts already, but the easing cycle is just getting underway. The high level of dispersion can offer great opportunities for active country selection and local duration or currency positioning. Meanwhile, corporate fundamentals are stable at strong levels.
Impact bond funds can be a good way to drive positive change, but do they actually help drive returns?
In fixed income investing, security analysis has traditionally focused on financial metrics. But we believe impact analysis can act as a great complement by uncovering additional layers of risk and opportunity — which may be overlooked by conventional analysis.
Applying an impact perspective involves a thorough examination of an issuer’s products and services to assess how the issuer’s offering helps end beneficiaries, but also to uncover any risks that could reduce the overall contribution to society and the environment and indirectly undermine an issuer’s business model. Seeking to establish an issuer’s ability to generate sustained impact over time also requires an in-depth analysis of its operations and governance, the broader dynamics within the markets and demographics it serves, and any structural tailwinds or challenges that could affect its longer-term impact potential.
In an uncertain economic era, we think anything that portfolio managers can do to better understand an issuer’s opportunities and risks — using as many lenses as possible — can help to enhance the potential for long-term alpha through security selection. Furthermore, the differentiated approach offered by an impact lens can help with overall portfolio diversification.
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