Cover story – Fixed income


“Lower US yields and a weaker US dollar would act as a tail- wind for the higher yielding areas of emerging market debt.”


What to buy? At current yields, short-term government debt also looks attractive to Scott Thiel. “Investors will increasingly ask for more compensation to hold long-term government bonds amid high-debt levels, rising supply and higher inflation,” he says.


Expanding on the case for high-grade credit, he adds: “We think it can hold up in a recession, with companies having fortified their balance sheets by refinancing debt at lower yields.”


Investment-grade corporate bonds are offering a yield of more than 5%, which could be a smart choice for investors open to a little credit risk while staying focused on quality. If interest rates decline, as expected this year, then the condi- tions bode well for stable and attractive bonds as this is the setting they need to flourish. Morgan Stanley’s fixed-income strategists have gone all out in predicting high single-digit returns this year from a range of issuers. These include German bunds, Italian government bonds, European investment-grade bonds, as well as in treas- uries, investment-grade bonds, municipal bonds, mortgage- backed securities issued by government-sponsored agencies and AAA-rated securities in the US.


That is quite a list for investors to digest, and indicative of the appealing nature of bonds. The one area it appears that inves-


tors should keep a close eye on is quality. Here US high-yield corporate bonds may look enticing, but they may not be worth the risk during a potentially extended default cycle.


Higher yields are a gift to investors who have long been starved of income.


Scott Thiel, Blackrock Investment Institute


Negative correlation Government bonds have typically been a source of balance in multi-asset portfolios, offsetting weakness in assets such as equities and credit during risk-off episodes. This has made them a cornerstone of the typical mature defined benefit (DB) portfolio, which relies on steady income streams. Bonds now account for more than 70% of DB portfolios of which more than 60% are invested in government bonds, according to the Pension Protection Fund. But the negative correlation between bonds and equities was broken during the pandemic. So, when stock market valua- tions contracted, bonds did not perform better as they typically would have done. But two key developments could well help the balance – or hedging – properties of bonds improve. First, historical evi- dence suggests that normalising inflation is consistent with the correlation between bonds and risk assets turning less positive, and eventually negative. Second, higher interest rates are pushing bond yields up, which could cushion weaknesses from equities or credit. This marks a change from the period following the global financial crisis when low yields limited the ability of bonds to buffer declines in risk assets. All this adds up to an environment where investors have to be slightly nimble to adapt to the changing nature of the fixed income markets and exploit opportunities where they exist. In this way, Meier reveals that New York City’s public sector pension funds already have a good allocation to fixed income, but this is going to see an adjustment. “We are looking to increase our holdings of private credit. It has performed con- sistently over the past several years,” he says.


Quietly optimistic


It appears that despite the upbeat outlook, investors, like Liz Fernando at Nest, are not getting carried away. “At Nest, we remain more cautious on the riskier end of fixed income, such as high-yield and emerging market debt.” Furthermore, investors have to be selective in their fixed income approach, with some assets being more equal than others. “Long-dated bonds face challenges,” Thiel says. Indeed, by locking in long-term commitments at today’s yields, investors may expose themselves to duration risks and miss out if yields rise further. Thiel, therefore, has a prefer- ence for short-term bonds and high-grade credit. In addition, in the sub-investment grade space, typically defined as lending to companies with a credit rating of BB or


20 | portfolio institutional | February 2023 | Issue 120


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