Fixed income – Cover story


We now see developed market sovereign bonds as, selectively, investible.


Liz Fernando, Nest


low correlation to mainstream asset classes,” she says, add- ing: “The underlying companies typically operate in a market where there are considerable barriers to new entrants and strong pricing power.” Deals in this space are often inflation-linked and ‘floating rate’, offering protection against inflation and rising interest rates. There is even the case within a dynamic and selective investment approach to lean towards the growing universe of green, social and sustainable bonds. “This is only suitable for long-term investors,” Buah says. “If you’re happy to be tied up in bonds for upwards of 10 years, it’s worth considering.”


below, yields have risen by more than investment-grade bonds. However, LCP’s Olivia Buah points to an indication of a “Covid hangover” evidenced by interest coverage ratios fall- ing, giving companies less money to make their debt pay- ments with and default rates increasing. “Investors should proceed with caution here,” Buah says. “We believe the best way to access sub-investment grade markets is via a multi-asset credit strategy.”


Data shows that investment-grade issuers have healthy bal- ance sheets and solid fundamentals. “This means they should be able to manage impending economic challenges and repay investors the money they have borrowed,” Buah says. “We prefer a buy and maintain approach when it comes to investment grade, where an investment manager buys high- quality bonds and aims to hold them to maturity,” Buah adds. “This offers a good balance between active and passive man- agement styles, which keeps transaction costs and manage- ment fees low.”


Niche benefits But the newly arrived appeal of fixed income also stretches into some niche areas. “Those who can afford to lock up their money for longer could look to illiquid credit, which range far wider than the more well-known ‘direct lending’ approach,” Buah says.


“Our view is that infrastructure debt offers a number of attractive features, including steady, reliable returns with a


Another option for investors looking for higher returns is opportunistic credit. Specialist managers can step in when a company is in a stressed situation, but they believe the com- pany will recover – often with the managers’ guidance and expertise. Typically, the debt is purchased at a significant discount, with large upside potential. With a potential recession looming in multiple markets globally, this could present more opportuni- ties for these managers to deploy capital at attractive prices. However, the natural proviso is that investors should always be mindful that with a high expected return comes a greater level of risk.


Tightening cycle We are now well into the interest rate tightening cycle, and markets expect UK rates to peak in the first half of this year and to stay elevated throughout 2023. On such an outlook, there is every reason to continue to have a positive view on fixed income. That is, as long as this outlook holds. Inflation will also play its part. The futures market for the Fed funds rate is predicting a peak at about 5%, which will be reached in April or May. This appropriately coincides with where core inflation is likely, or expected, to be. If market expectations prove correct, for inflation to be around 3.5% by the end of the year, then US treasuries, through the 10-year maturity, are yielding more than that. That means their inflation-adjusted, or “real,” yield could turn positive. Meanwhile, municipal and corporate bonds are providing an extra 1.5% to 2.5% beyond treasury yields. But despite the positive outlook in fixed income, Fernando fires a warning. “Whether bonds are good value or fair value depends heavily on whether you believe we will return to a post great financial crisis low growth, low inflation world or remain in a higher inflation, higher volatility world.” Border to Coast’s Loughney offers a positive outlook. “With the more attractive valuations in credit and government bonds it is an opportune time to rebalance into fixed income.”


Issue 120 | February 2023 | portfolio institutional | 21


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