- Investment Director
United States, Institutional
Change
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Uncertainty is a hallmark of the current investment landscape. The world is coming to grips with a likely sweeping US tariff plan that was announced, rolled out, and put on a 90-day pause all within the span of one week — a whirlwind that speaks to this uncertainty. What’s more, higher inflation is becoming the norm and global central bank policies are diverging more than they have in decades. In fact, central banks haven’t been so out of sync for an extended period of time since the 1970s. This adds another layer of uncertainty, especially for market participants who joined after that period, for whom this dynamic is new.
Concerns for today’s investors
Against this volatile backdrop, equity market valuations are elevated. US equity markets rely heavily on a small group of mega-cap stocks for outperformance. Consider that for the calendar year 2024, the S&P 500 Index, a proxy for the US equity market, generated a 25% annual return. The same index, minus one high-performing tech company, NVIDIA, generated a 20% return over the same period. If you were to remove the whole “Magnificent Seven” (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla) from the equation, the same index returned 12% during this time.1 Significant exposure to such a top-heavy market may be rewarding at times, but there are great risks, as well.
Fixed income markets are not without their caveats, either. Fixed income investors in search of alternatives to equity markets have often turned to private credit, but dry powder in middle market direct lending, the single-largest component of the asset class, is near historical highs. We believe this could be a warning sign there may be too much money chasing and too few deals, potentially foreshadowing lower future returns.
Return-seeking fixed income — a potential solution?
With equity markets so concentrated and dry powder in certain areas of private credit potentially peaking, investors may consider fixed income that focuses on generating returns beyond just the coupon payment, aiming for total return, rather than just income.
Investors may access return-seeking fixed income through actively managed strategies, which have the flexibility to allocate across different geographies and sectors, arguably an essential in a world so marked by policy divergence. These approaches tend to be global in nature with no single-sector bias. As such, they can be a useful source of portfolio diversification.2
What’s more, active managers in this space tend to have a deep understanding of market fundamentals, such as direction of the economy, interest rates, and the financial strength of a given company or sector. This could be especially important in an age where Treasury-rate volatility seems likely to persist amid ongoing economic and geopolitical uncertainty.
Active return-seeking fixed income managers are often well versed in technicals, such as demand/supply imbalances, and investor segmentation, as well. They have the freedom to analyze duration, yield-curve positioning, credit, and relative value in such a way that could enable them to pursue returns through a thoughtful, risk-aware lens.
As a result, these strategies can potentially open investors up to a wider range of opportunities among inefficient, largely overlooked, noncore sectors, such as convertibles, capital securities, and AT1. Single-sector managers aren’t as likely to take advantage of these opportunities.
In our view, experience, diversification, and ability to pivot is essential in a world where market volatility can spike at the drop of a hat (or social media post, or unexpected policy announcement). Figure 1 illustrates how both investment-grade and high-yield fixed income have reacted over major spikes in volatility in recent years, such as the COVID pandemic in 2020, the onset of the war between Russia and Ukraine in 2022, the summer of unwinding global trade carry in 2024, and this year’s “Liberation Day” announcement of the most protectionist US trade policies in a century.
Figure 1
Return-seeking fixed income managers with flexible mandates can better take advantage of mini dislocations like these in real time. So, they may be able to dampen portfolio volatility and identify short-term mispricing and dislocations, thus aim to generate risk-adjusted returns across broad global fixed income markets.
Uncertainty creates opportunity in fixed income
Our uncertain world calls for a different approach than investors have grown comfortable with in recent history. Equity markets today are highly concentrated, and the heavier they are, the harder they may fall in the face of volatility. A potential solution to these challenges comes in the form of return-seeking fixed income. The active managers who oversee these types of adaptable, flexible strategies may be well positioned not only to avoid some of the risks today’s uncertainty brings, but also to find the opportunities it creates.
1 Wall Street Journal, S&P Dow Jones Indices, Bloomberg | 31 December 2023 – 31 December 2024 PAST INDEX OR THIRD-PARTY PERFORMANCE DOES NOT PREDICT FUTURE RETURNS. | 2 Diversification does not ensure a profit or guarantee against loss.
