A new path for bond investing: where are the challenges and opportunities for DC investors?

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. At Wellington, we have held numerous discussions on what this means for our clients, involving both our investment and client-facing professionals. The below conversation between Paul Skinner, fixed income investment director, and James Myhill, account manager, crystallises our latest thinking on how best to approach this new environment.

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 largely 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 market upheaval. 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. Having discussed this extensively within Wellington, we think there are four considerations that stand out.

Firstly, 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. 

Secondly, 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. 

Thirdly, 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. 

Finally, recent events in the UK and the US 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 or further instability wrongfoot the market, we expect further volatility — bringing with it opportunities for active managers to outperform.

How are defined contribution (DC) investors looking at fixed income at the moment?

James: Fixed income in DC has a multifaceted role to play. While most DC members have fixed income exposure, traditionally, much of the focus has centred on building appropriate solutions for members nearing retirement. Against this new market backdrop, we see a real opportunity to have all members benefit more from fixed income’s attractive features of liquidity, yield and diversification potential. We see a number of ways of doing that.

First of all, schemes can capture the attractive long-term return potential that is now on offer through diversified exposure to the asset class. Today’s risk/return profile is fundamentally attractive, with higher yields rendering bonds increasingly competitive versus equities, and while from here developed market interest rates may fluctuate, we do not expect a return to the previous low-yield environment.

Secondly, DC investors can optimise diversification. As mentioned earlier, last year we saw correlations between fixed income and equities turn positive, and it is likely that in this new, more cyclical world correlations will remain more volatile. As long-term investors, DC schemes are well positioned to take advantage of the associated repricing to capture opportunities. At the same time, DC schemes can use diversification within the asset class to help dampen volatility and maintain appropriate risk levels across the cycle. In practice, we think that fixed income allocations that combine top-down sector rotation with bottom-up credit and ESG research offer the greatest potential for return consistency, downside protection and low correlations to traditional market betas.

What are the key challenges for UK DC investors looking to invest in fixed income?

James: Sustainability integration is a real challenge for DC investors. UK DC investors are increasingly aware of how risks such as climate change can impact financial markets’ risk-adjusted returns. However, the heterogeneity of the fixed income universe presents both opportunities and challenges for fixed income managers and allocators alike who want to make ESG or sustainable investing a priority. For that reason, we think careful consideration of ESG factors and sustainability is a key part of evaluating credit opportunities. Again, DC investors can capitalise on their members’ decade-long investment horizon to invest in long-term solutions that meet financial goals but also deliver a real impact from a sustainability perspective. We are also strong believers in proactive engagement to help portfolio companies evolve and drive value. 

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 MIT Joint Program on the Science and Policy of Global Change. For portfolios with climate considerations or objectives, this allows for explicit integration of both physical and transition risks into portfolio management from a top-down and bottom-up perspective, incorporating sector and industry-specific risks.

Moreover, reporting on the integration of sustainability is critical, especially for UK DC plans — this can also be an effective tool for member engagement. For our article 8 and 9 funds, Wellington delivers deep reporting across the fixed income platform, and this can be used for UK DC member engagement.

Value for money is an imperative for DC schemes, so it’s crucial that solutions are cost effective. At a time of increasing volatility and differentiation across issuers, actively selecting and monitoring portfolio exposures is increasingly important. We believe in cost-efficient access to active credit management and all our DC UCITS offerings are priced to deliver high-value liquid credit solutions for schemes and their members.