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.
Monthly Market Review — August 2024
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Brett Hinds
Jameson Dunn