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Are bonds getting back in the game after a historically challenging stretch? Multi-Asset Strategist Adam Berger and Fixed Income Strategist Amar Reganti consider the evidence and the asset allocation implications.
Adam: The past year was an eventful one for bond markets. How different is the picture today compared to where things stood early in 2022?
Amar: It is almost completely different. It wasn’t long ago that yields were near or even below zero in developed markets, and from a valuation perspective, fixed income did not present a terribly compelling argument. Now, even the highest-quality fixed income instruments have a yield to worst in the mid-single digits. And further out in the risk spectrum, in areas like high-yield and emerging markets, the yield to worst is in the high single digits in many cases.
The other big change in 2022 was that volatility and uncertainty came roaring back. This was driven first by the Fed’s shift from treating inflation as transitory to something more pernicious, which signaled the end of the volatility-dampening easy-money era. Then came the war in Ukraine and its effect on energy and supply chains. The impact of these events is evident in the volatility of the 1 year – 10 year swaption, which is a good proxy for the band of uncertainty around what the 10-year Treasury rate will be one year from now (Figure 1).
That said, we may be near the limits of some of this volatility. At this stage, the US Treasury curve indicates that market participants expect what might be described as a classic bull steepening, where front-end rates fall and then long-end rates decline as well, but not by as much. We typically see this when we come to the end of a tightening cycle or the beginning of a loosening cycle.
Adam: How did the low-yield environment of recent years affect allocation decisions, and where do we go from here?
Amar: Allocators reacted to the hand they were dealt by the bond market. They still used fixed income for its diversification benefits and as a hedge against a deflationary event within the broader economy. But as noted, yields were lacking for an extended period and some allocators really had to reach for yield. Today, however, yields may also offer investors better entry points into some fixed income assets (Figure 2), as well as a potential cushion against further interest-rate volatility in the months ahead.
I’d also note that the low-yield environment of the past decade drove innovation in financial markets, and especially the rapid growth of the private credit market, which offered more of the total return that was lacking from traditional fixed income and now plays a key role in many portfolios.
Adam: What is your outlook for Fed tightening and how does it impact your view on fixed income positioning currently?
Amar: The Fed has not quite seen inflation move down as fast as it wanted or expected. The US banking issues and their impact on credit availability could accelerate that process, but we’ll have to see whether that is enough to get the Fed comfortable taking its foot off the policy-tightening pedal. In the meantime, it’s very possible we could see other market disruptions. The Fed is aware of this, of course, and is likely to provide as many facilities as possible to make sure nothing “breaks,” although technically something did break in banking over the last couple of months.
Against this backdrop and looking across our fixed income strategies broadly, I think we definitely have a bias toward better liquidity and a little bit less credit beta. There’s also stronger interest in using duration again, as a general risk offset and as a form of “deflation insurance” in the event the Fed goes too far with tightening and pushes us toward an even deeper recession than anticipated.
Adam: Can you share a few areas of opportunity you’re seeing in the fixed income market?
Amar: In the near-term, I think some of the more “boring” agg-related types of strategies are attractive, given improved yields. I know some are concerned about curve inversion, but we’ve often seen in the past that as tightening takes effect and the economy slows into a deflationary or recessionary period, the curve inversion goes away and investors often regret not taking advantage of the fact that intermediate or longer yields were substantially higher — that’s what drives the convexity that’s so important in total return.
I also think macro fixed income strategies, which have been underutilized recently, are worth a close look. They can seek to take advantage of the volatility in interest rates and currencies, particularly during a period of asynchronous central bank policy tightening around the world. I would also consider long/short credit strategies, given their potential to capture premia within credit but with less beta, ideally, than a long credit allocation.
As we move closer to recessionary conditions, I would consider areas like CLO equity, which can potentially take advantage of wider spreads, and diversified credit strategies, which can rotate into the cheapest credit market sectors. Lastly, I think the situation in the US banking system, while not as bad as 2008 – 2009, will require a recapitalization process for select companies or across certain segments of the banking industry, and that could be an attractive area for patient investors who have capital to deploy.
Adam: I’ll close by sharing a few of my own thoughts on fixed income:
Time to add to fixed income allocations?
For allocators who reduced their fixed income exposure over the past 5 – 10 years, I believe the new higher-rate environment justifies adding some back. For those who maintained their exposure all along, I’m not sure there’s a strong case yet for going above target. While we see higher expected returns ahead, as reflected in our Investment Strategy team’s capital market assumptions (CMAs), that may be offset somewhat by a reduced fixed income diversification benefit. As I’ve noted before, if the battle against inflation continues, we are likely to see more scenarios like 2022, when both stocks and bonds fell at the same time, undermining a key source of diversification. I’d also point out that after a challenging 2022, our CMAs are higher not only for bonds but for equities as well. That might argue for adding back to core equity/fixed income allocations, as opposed to overweighting fixed income.
A different role for fixed income
While bonds may not have a bigger role to play, they could have a different role: In a world where fixed income may not be quite as diversifying, investors may want to lean into bonds as a return generator. As Amar noted, timing is critical. If we’re heading into a recession, now may not be the moment to add credit risk. But at some point over the next year or two, and with the next decade in mind, there may be an opportunity to add more growth fixed income — perhaps even shifting some assets out of equities and into growth fixed income, if the latter may offer a reasonable return and less risk. To be sure, in a world where bonds are more correlated to stocks, investors may need to seek out other potential sources of diversification, including alternative investments, commodities for an inflation-sensitive world, or more defensive and resilient equity investments.
The future of 60/40
While some have predicted the end of the 60/40 model, I think what happened with rates over the past year actually suggests a healthy future for the traditional equity/fixed income mix – given higher expected returns for both markets, as indicated in our CMAs. But some tweaks to the 60/40 mix may be in order. In our multi-asset portfolios, we are typically adding growth fixed income exposure and seeking diversification with exposure to commodities or liquid alternatives. Recognizing the challenges of finding diversification, we often incorporate defensive equities as an exposure that may mean we don’t need as much diversification when equities sell off. We also use active asset allocation — tilting away from the 60/40 mix over time to take advantage of opportunities created by higher levels of volatility and dispersion — as well as opportunistic strategies and flexible duration approaches in fixed income. Finally, notwithstanding my earlier note of caution on boosting bond exposure today, allocators should stay on the lookout for bond yields approaching their return target, which could signal an opportunity too good to pass up.
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