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n today's evolving economic landscape, fixed income investments are regaining their historic significance, able to offer both income and downside protection. But a new
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bonds REVISITed
A new economic era: Three reasons to revisit bonds
Opportunities in high yield: ready, steady, pounce?
Diving into the new world of credit
Is it time for allocations to change too?
The fixed income landscape is changing
FOR PROFESSIONAL INVESTORS ONLY
Spotlight on: fixed income at Capital Group
High-yield bonds, in particular, may offer the potential for equity-like returns, but with better downside protection. While caution is warranted, is now the time to consider a strategic allocation to high yield?
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investment era could challenge some long-held assumptions. In a more complex and volatile environment, understanding the new opportunities and challenges within the bond market is crucial.
Central banks are starting to cut rates, but bond yields are likely to remain attractive. By moving out of cash and into fixed income, investors can potentially lock in higher yields and avoid reinvesting in a lower-rate environment.
For professional investors only
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bonds revisited
ixed income markets have gone through a painful transition, but the outlook is now a lot more positive. Volatility and risk are far from off the
Opportunities and risks in an improved environment for fixed income
Above all, in today’s more cyclical, complex and volatile environment, how can an active approach, encompassing deep research and insight into geopolitical developments, inflation and economic cycles help give investors the best chance of success?
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e believe that in this more cyclical era, bond investors can capture attractive income across the quality spectrum, but doing so may involve proactively revisiting widely held assumptions.
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Marco Giordano, Investment Director, and Derek Hynes, Portfolio Manager at Wellington Management, explore the risks of relying on cash in the current market environment, arguing that bonds may offer a more reliable income stream and downside protection as central banks approach rate cuts.
We have seen significant flows into cash and cash-like products over the last two years, driven by the fact that cash has been able to offer a healthy yield at low levels of risk in an uncertain environment. However, while this sounds appealing, it is not entirely without risk. Once a growing percentage of central banks start to cut rates, short-term rates will adjust quickly, and with each cut, investors’ exposure to reinvestment risk will translate to ever-decreasing interest earned on assets.
With cash providing a healthy yield, isn’t it better to wait for clarity from central banks?
True, credit spreads tightened significantly in 2023 leaving limited scope for further spread compression. That said, we believe that earning the credit spread should continue to be attractive, even if no further material tightening takes place.
Now that spreads have tightened, is it too late to invest in credit?
A major global recession does not appear to be on the table; in fact, global purchasing managers’ indices are suggesting growth may well accelerate. Consumers remain relatively robust and companies seem to be well-capitalised. While we see weakness in certain sectors, we expect that the credit cycle will be extended and foresee no maturity wall with companies forced to refinance en masse. These circumstances suggest that spreads could well remain tight. In other words, given the likely absence of a significant downturn, why not earn the credit spread, even if spreads might not tighten materially like they did last year?
Marco Giordano, Investment Director
Crucially, as well as offering an income stream similar to cash, high-quality bonds also embed downside protection, should central banks deliver on rate cuts in the near term. We can see evidence of this by looking at similar periods in the recent past where cash has tended to underperform all major fixed income categories once rate cuts got underway.
“An extended period of rate cuts typically supports economic growth, which can lead to tightening spreads, which benefit corporate bond investors”
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Bonds are back, although risks persist
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The case for a global fixed income approach
“We believe bond investors can capture attractive income, which contributes to total returns, at all points in the quality spectrum”
Markets may still be anchoring to the old regime of central banks stepping in when the pressure gets too high, but we think the age of easy money is gone, meaning that passive portfolios may be more vulnerable than in the past to the adverse impact of deteriorating credit conditions.
What can an active approach offer me that passive can’t?
Active managers can also identify downgrades before they happen. At the end of 2021, the Bloomberg Euro Aggregate Corporate Index held 96 real estate issuers. As of 30 June 2024, that number had dropped to 82 as some issuers have been downgraded and left the index. Fundamental research can help active managers identify deterioration or improvement in a credit before the rating agencies do, and even before the shift is priced in by markets. At the very least, higher leverage should be a clear warning sign for credit teams to investigate a company’s earnings and free cash flow, its plans for asset sales and dividends and how committed its senior management is to investment-grade ratings.
The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
where we see opportunities for fixed income investors.
ixed income is looking attractive once again, but risks, as well as opportunities, abound. Here’s what’s keeping us up at night – as well as
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Justin Webb, Head of Investment Solutions
Find out more about Wellington Management's solutions for a new economic era
Relocating the fixed income opportunity — the case for going global
Blue bonds: long-awaited innovation or yet to make a splash?
Specifically, we analysed the three-year total returns of cash, government bonds, corporate bonds and short-duration corporate bonds starting from the last hike of each of the past six full US Federal Reserve interest-rate-tightening cycles since 1980. As Figure 1 illustrates, returns for all types of bond strategies were significantly higher than cash: even though some bonds have lower yields than cash, on average they've benefited materially more than cash in the past six rate-cutting cycles.
Source: Bloomberg Finance L.P. Each data series represents the cumulative monthly return for three years since the first hike of each tightening cycle. The tightening cycles are: March 1983 – August 1984, March 1988 – May 1989, February 1994 – February 1995, June 1999 – May 2000, June 2004 – June 2006 and December 2015 – December 2018. Aggregate bonds represented by the Bloomberg US Aggregate Total Return Index. Corporate bonds represented by the Bloomberg US Corporate Total Return Index. Treasuries represented by the Bloomberg US Treasury Total Return Index. Cash represented by ICE BofA US 3-month Treasury Bill Index. Chart data as of 27 July 2023
PAST PERFORMANCE DOES NOT PREDICT FUTURE RETURNS.
Figure 1: Average next 3-year returns following last hike: cash underperforms
Why does cash underperform versus fixed income in those circumstances? First, fixed income investors don’t have to reinvest in a lower-interest-rate environment, as they have already locked in higher yields. Second, the duration component of bonds tends to boost performance in the event that the mid or long end of the yield curve is also adjusting downwards. Finally, an extended period of rate cuts typically supports economic growth, which, in turn, can lead to tightening spreads, which benefit corporate bond investors.
While all high-quality fixed income categories in the above example outperformed cash, longer-duration bonds tended to outperform shorter-duration bonds. However, we should remember that longer-term bonds are associated with higher volatility. If the potential interest-rate volatility is perceived as too risky, short-duration approaches can allow for a spread pick-up relative to cash while also benefiting from inverted yield curves (higher rates in the shorter end of the curve) with moderate rates exposure and therefore lower expected volatility.
One key way in which an active approach can help investor outcomes relates to the composition of indices. By investing passively in investment-grade credit, investors are bound to the sector and issuer exposures of the reference index. This can be a problem if investors are inadvertently exposed to risks they would rather not take, which may be exacerbated in an era of cyclicality and divergence.
The recent travails faced by the European property sector illustrate this problem. As elsewhere across the world, real estate in Europe benefited greatly from ultra-low interest rates. Between 2018 to 2022, the sector’s weight in the Bloomberg Euro Aggregate Corporate Index grew from 3.3% to 7.6%. However, as the impact of higher interest rates began to bite, the sector materially underperformed the rest of the European corporate index. As a result, passive investors were significantly exposed to undesirable risks, by virtue of tracking highly indebted sectors and issuers.
In the new regime, we believe bond investors can capture attractive income, which contributes to total returns, at all points in the quality spectrum, but it is important to make sure that outdated assumptions don’t stand in the way of success.
Could high-yield bonds help unlock opportunities in a volatile market? Wellington Management's Investment Director Marco Giordano and Portfolio Manager Konstantin Leidman discuss the strategic role of high-yield bonds in a diversified portfolio, challenging the assumption that higher rates are necessarily detrimental to bond investors.
alongside downside protection and the opportunity for capital appreciation. However, we believe targeting growth in this environment requires a different mindset, challenging some of the assumptions below.
e believe fixed income investors face a fundamentally different economic era, with new risks but also compelling opportunities. Bonds are now regaining the role they have historically had in portfolios: offering income
Even with central banks cutting rates, they are likely to remain higher for longer. Isn’t this a bad thing for bonds?
High yield can offer attractive opportunities as a shorter-term trade, but does it make sense as a long-term, strategic allocation?
Rates staying higher for longer isn’t necessarily a negative for fixed income investors. Bonds provide higher and more attractive yields, which can be helpful in an environment where investors face so much uncertainty related to geopolitics, inflation and a significant global election cycle.
We believe there is a compelling case to be made for investing in high-yield bonds within a strategic asset allocation.
“Fixed income investors face a fundamentally different economic era, with new risks but also compelling opportunities”
Blue bonds - a long-awaited innovation?
First, based on historical risk and return characteristics, high yield has the potential to offer comparable returns to equities, but with a lower correlation to equity market beta and better downside protection. Second, given the income-based nature of the return stream, high yield can also offer a narrower set of outcomes relative to equities and therefore an attractive risk and return profile. Finally, high-yield bonds have a relatively low correlation to other fixed income assets, as well as a different sector composition and different risk drivers relative to broad market equities, helping to enhance diversification in a multi-asset portfolio.
All-in yields — a comprehensive measure of a bond’s return — remain very attractive, creating a compelling entry point for clients seeking higher total return potential. In addition to this, high yield tends to have lower duration than other fixed income categories, meaning it is less exposed to rate volatility. Our default expectations are well below previous recessionary peaks, with default rates likely having already peaked. Figure 1 depicts the minimum yield available (yield to worst) for the universe over time, highlighting how, based on the ICE BofA Global High Yield Constrained Index, yields are high relative to history. Spreads have also tightened significantly but remain supported by positive supply/demand dynamics.
“This could be an environment where spreads are quite boring, either moving sideways or slightly lower over the next 12 months”
Alex King, CFA, Investment Strategy Analyst
Fresh thinking for a new economic era: Is now the right time to invest in bonds? Find out more
Green bonds remain the most popular form of use-of-proceeds bond, but investors are increasingly interested in blue bonds, which aim to support projects related to ocean protection and conservation.
onds that finance specific sustainability-focused projects or activities – also known as use-of-proceeds bonds – are on the rise.
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John Butler, Macro Strategist
We believe that higher yields reinforce the positive role of bonds in a broadly diversified portfolio, delivering ongoing income as well as downside protection. Our research suggests that even for a standard 60% equity/40% bond portfolio, income can potentially contribute more than half of the returns over a five-year investment horizon. If investors choose asset classes with a higher income profile, such as credit or high-dividend-income equity, that proportion can increase, reaching as much as 80% in some cases. While a shallower cutting cycle may be more challenging for weaker issuers, it can offer greater opportunities for adding value through careful security selection.
Source: Bloomberg Finance LP, ICE Data Indices, LLC (“ICEDATA”), is used with permission. Index used is ICE BofA Global High Yield Constrained Index. Chart data: 1 August 2013 – 30 June 2024.
Figure 1: Despite tightening, yields present opportune entry points
The investment environment remains uncertain and volatile, so caution is indeed warranted. However, current all-in yields provide a meaningful cushion to investors, and we think the growing differentiation among sectors and regions in the high-yield market is starting to create attractive opportunities for bottom-up focused investors, with Europe currently the standout region.
With greater volatility likely on the horizon, isn’t high yield too risky?
In this type of uncertain environment, it’s even more important to prioritise companies with sustainable competitive advantages and avoid sectors experiencing increased capacity. These durable competitive benefits can be, for instance, having a cost advantage that is hard to replicate or possessing high-quality intangible assets such as a brand or patent.
When investing in high yield, fundamental research and security selection are crucial, as they can help investors avoid companies with poor credit profiles or those that might be vulnerable to the increased cost of financing in a higher-rate environment.
It’s important to recognise that there are risks to the economic outlook and further volatility is likely. However, opportunities in high yield are emerging, particularly in Europe, provided that investors are willing to do the research and venture into “out-of-favour” areas of the market.
ICEDATA, its affiliates and their respective third-party suppliers disclaim any and all warranties and representations, express and/or implied, including any warranties of merchantability or fitness for a particular purpose or use, including the indices, index data and any data included in, related to, or derived therefrom. Neither ICEDATA, its affiliates nor their respective third-party suppliers shall be subject to any damages or liability with respect to the adequacy, accuracy, timeliness or completeness of the indices or the index data or any component thereof, and the indices and index data and all components thereof are provided on an “as is” basis and your use is at your own risk. ICEDATA, its affiliates and their respective third-party suppliers do not sponsor, endorse, or recommend Wellington Management Company LLP, or any of its products or services.
As the economic landscape continues to be marked by persistent inflation and ongoing uncertainty, is it time to revisit the role of bonds in investment strategies?
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Bonds are regaining their prominence in investment portfolios.
In a new macroeconomic environment, characterised by higher inflation and ongoing uncertainty, bond yields are expected to remain elevated, potentially providing opportunities across the quality spectrum.
According to Marco Giordano, Investment Director at Wellington Management, there are three reasons why it could be time to revisit bonds:
Income: Central banks are beginning to cut rates, but bond yields should remain attractive. In this new environment, bonds should be able to offer attractive income at all points of the quality spectrum.
Downside protection: Income from bonds is not only attractive in its own right but has historically outperformed cash. The consistent income offered by carefully selected credit investments can help to stabilise returns amid more frequent and shorter cycles.
Diversification: As policymakers withdraw the liquidity injected into markets over the past decade, volatility is likely to increase. Bonds – spanning core credit, high yield and emerging markets – can offer a strategic way to diversify portfolios.
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