In our last blog post, we described the secular forces that we believe are driving the transition to a new fixed income reality characterized by more frequent market dislocations. Here, we lay out four steps investors can take to build a new fixed income allocation that is equal to today’s challenges and opportunities.
1. Rethink how to construct a fixed income allocation.
It’s best to start with what we know has changed. We know that inflation may be poised to rise in many countries, which could have important implications for global currencies and interest rates. We know also that the fixed income markets have evolved to become increasingly complex and dynamic.
What hasn’t changed for many investors are the objectives fixed income is supposed to pursue — income generation, total return, capital preservation, diversification, and liquidity (Figure 1). Articulate your main objectives and structure your portfolio accordingly, recognizing that a single, all-purpose fixed income allocation may no longer be up to all of those jobs. We believe a more nuanced approach is required.
2. Invest in strategies that (individually and collectively) target your objectives.
For example, high-quality fixed income has historically played a valuable role in diversifying an overall portfolio. Interest-rate duration serves as a counterweight to other portfolio risks when spikes in volatility that impact risk assets (such as equities) pull down bond yields and push up bond prices. Longer-duration bonds can provide both dependable income, which mitigates reinvestment risk when bond yields head dramatically lower, and convexity,1 which helps boost returns when rates are volatile through favorable asymmetric responses to yield movements.
Conversely, allocations to higher-yielding credit sectors — such as high-yield bonds and emerging markets debt — can magnify current income, enhance fixed income diversification, and offer a lower-risk alternative to equities.
3. Ensure your strategies are flexible enough to accommodate a variety of possible outcomes.
This type of flexibility is key because investment risks and opportunities are likely to shift over time. As such, defensive risk postures and opportunistic return-seeking strategies should not remain static through the different phases of the business cycle or investors might miss out. Many of the most compelling opportunities arise when there are unsynchronized economic, interest-rate, and credit events that lead to inefficiencies in the fixed income markets.
In our view, the best way to consistently identify and capture these opportunities is to utilize diversified, independent sources of alpha (excess return), followed closely by the ability to adapt on the fly as needed.
4. Be selective in credit markets and active in interest rates.
We believe this is important in order to take advantage of dislocation, volatility, and asset pricing disparities. Credit valuations appear less attractive than they were after the recent bout of spread tightening, but the potential disparity between credit “winners” and “losers” is greater amid sharp fluctuations in consumer sentiment post-pandemic. The inflection point for inflation counterbalanced by central bank actions likely means a more volatile interest-rate picture, so investors should look to capitalize by taking active positions (long- and short-duration or long/short credit).
With economic growth paths also likely to diverge going forward, investors should seek to actively manage their interest-rate exposures accordingly by global region and country.
We believe these four steps may help investors craft a more resilient fixed income allocation that can: a) navigate the current period of transition to a potentially inflationary, higher-rate environment; and b) nimbly respond to evolving market conditions, including both new risks and new opportunities.
1Convexity is a measure of the curvature in the relationship between bond prices and yields. It demonstrates how the duration of a bond changes as interest rates change.