After a strong economic rebound in 2021, we’ve entered a new phase for the markets, one in which economic growth across many global economies is expected to slow precipitously while faced with a combination of high inflation, geopolitical conflict, and fading fiscal tailwinds.
Many global central banks, including the U.S. Federal Reserve (Fed), have also begun withdrawing monetary policy support at an accelerated pace by tapering bond purchases, reducing balance sheets, and raising short-term policy rates in an attempt to tamp down the highest inflation rates in the past 40 years. The risk of a monetary policy “mistake” is higher today than at any point since the global financial crisis and the potential for higher volatility as liquidity is removed from the market is significant.
The critical challenge fixed-income investors face today is to find stable returns in an environment of high inflation and below-average but rising yields—and to do so without taking on excessive volatility or risk. Many investors have decided to allocate capital away from fixed income altogether or into less understood areas such as private debt and alternative assets strategies, and in doing so sacrifice the liquidity and stability historically offered by high-quality, publicly traded bonds.
To date, 2022 has been characterized by high volatility and a new bear market for equities; however, in the background, global bonds have also experienced record drawdowns. With global economies still mired in clouds of uncertainty, suddenly the case for rotating back into fixed income has become more compelling. Valuations across several areas of the bond markets are now more attractive than they have been in recent history; in fact, all major fixed-income sectors currently trade at a discount to par. The uncertain macroeconomic backdrop, however, has kept investors on the sidelines, with a soft landing, stagflation, or a full-blown recession all distinct possibilities. For asset allocators, positioning a fixed-income portfolio for success may not be as clear a task as in the recent past. How do fixed-income investors opportunistically position a portfolio going forward without taking on further drawdown risk?
Average price of global bond market indexes
|Global Treasury ex-U.S.||99.25|
|EM Local Currency Sovereign||96.72|
|U.S. Asset-Backed Securities||96.24|
|U.S. Investment Grade CMBS||93.49|
|U.S. Corporate Investment Grade||91.87|
|U.S. MBS: Agency Fixed Rate MBS||91.86|
|EM USD Aggregate: Corporate||86.74|
|U.S. Corporate High Yield||86.18|
|EM USD Aggregate||83.48|
We believe the answer is neither to take on additional risk, nor is it to avoid risk altogether by fleeing to cash. Rather, we feel taking a flexible approach to fixed income is the best prescription for today’s challenges. In this market environment, success requires the ability to pivot quickly to embrace targeted risks as market dislocations arise or to reduce risk as liquidity conditions tighten. Seeking the outperforming segments across sectors, industries, and regions while avoiding the underperforming areas could be a meaningful difference-maker as investors try to navigate the about-face in monetary policy and economic fundamentals. To that end, after careful evaluation of total return potential versus several key risk factors, we believe several areas of the global fixed-income markets may be worth a closer look.
Global government yields are increasingly more attractive
Developed-market interest rates have moved materially higher this year against the backdrop of heightened market volatility, higher inflation, and tighter monetary policy.
Global government bonds now offer an average yield of 2.3%, up more than 200 basis points from the record low of 0.2% hit in July 2020. Furthermore, 10-year yields across the largest developed fixed-income markets now exceed the average of the past decade.
Higher interest rates have historically led to higher returns for fixed-income investors as fresh issuance is brought to market at higher coupons, and the current environment should be no exception. In addition, with global developed yield curves pricing in a series of aggressive rate hikes, if central banks hit the pause button later in the year due to weaker economic data or moderating inflation, high-quality bond yields may actually move lower to reflect a more gradual pace of rate hikes. A scenario where central banks are less aggressive in the coming months would also suggest incremental total return prospects in high-quality bonds through price appreciation. It’s the kind of environment where active managers can earn their keep through country, currency, and sector selection, as well as by targeting the most attractive areas of individual market’s yield curves.
Against such a backdrop, it could be time again to add duration to a portfolio through high-quality government bonds and move on. But such a move isn’t without its risks, as government bonds, even after recent yield increases, still offer insufficient income to cushion against a further rise in interest rates, in our view. Moreover, the Fed and other major central banks are actively shrinking their balance sheets, which has the potential of keeping upward pressure on interest rates if aggregate demand declines.
Finally, and perhaps most importantly, real government yields remain negative with nominal yields running well below current inflation levels. The last time U.S. inflation was rising at a comparable rate was in 1978, at which point the trailing 12-month performance for the Bloomberg U.S. Government/Credit Index failed to outpace the year-over-year Consumer Price Index for the following four-plus years. In December 1978, the yield on that index was 9.78%, which represented a significant amount of income to offset the impact of rising rates. Currently, the U.S. Government/Credit Index offers just over one-third of that yield, at 3.74%, which makes it much more challenging for high-quality U.S. bonds to deliver positive real returns going forward.
The fundamentals in credit may be stronger than valuations suggest
With high inflation, increased geopolitical tension, and tighter monetary policy, it’s no surprise that credit spreads have widened over the past 12 months. The combination of higher global interest rates and wider spreads means that yield levels are now at 10-year highs, or more, in certain sectors. For example, excluding a dramatic and rapid sell-off during the height of the COVID-19 pandemic, the yield to worst for the Bloomberg U.S. Corporate High Yield Bond Index was approaching 9% for the first time since 2019 while BBB-rated U.S. corporates offer their highest outright yields since the financial crisis, currently at just over 5%. Coupled with low defaults, declining leverage levels, and a favorable technical backdrop, we believe there are still pockets of opportunities within corporate credit sectors.
Meanwhile, emerging markets have faced a number of shocks in 2022, not least of which was the Russian invasion of Ukraine, China’s property sector concerns, dubious monetary policy in Turkey, and potential debt and food crises in various frontier markets, which have all weighed on the emerging-market segment as well. However, we believe that many higher-quality sovereign and corporate issuers have become oversold as they dislocated in concert. While tighter liquidity conditions in developed economies present a risk for emerging markets, earlier inflation pressure in these economies means many emerging-market central banks have preemptively—and aggressively—hiked policy rates already. Policy rates in Brazil, for example, are at a five-year high of 13.25%. This proactive policy making by central banks in emerging economies has sent the average cash rate in the segment above 5.25% for the first time since 2016. By being highly selective within the space, we believe experienced investors can take advantage of attractive discounts and incremental income within the broad emerging-market debt space.
Finally, after underperforming on a relative basis throughout the majority of the pandemic, new opportunities appear to be reemerging in securitized assets. After the conclusion of the Fed’s program to purchase mortgage-backed securities (MBS), spreads widened significantly in 2022, and in some cases now exceed those of comparable-quality corporate bonds. The result has sent yields on agency MBS above 4% for the first time since 2011. Beyond yields, we believe the asset class—through various niche subsectors, such as whole business securitizations, credit risk transfer securities, and single asset/single borrower commercial MBS—also offers the added benefit of enhanced diversification potential.
Targeted currency exposure can be a potent source of diversification and alpha
Global bond exposure can offer investors a wide variety of benefits, including relative yield opportunities and diversification away from domestic interest-rate movements; however, whether in the form of developed- or emerging-market government bonds, foreign currency risk can have a significant influence on the total returns of fixed-income allocations. Currency fluctuations can easily wipe out the returns on low-yielding fixed-income securities. But hedging away all currency risk (back to an investor’s base domestic currency) virtually eliminates the diversification benefit of a global allocation. Looking at an analysis of the five-year rolling correlations between the Bloomberg U.S. Aggregate Bond Index and the Bloomberg Global Aggregate Bond Index reveals that a fully hedged global portfolio provides little in the way of diversification for U.S. fixed-income investors.
In contrast, while history would tell us that the U.S. dollar is potentially peaking at this point in the Fed’s hiking cycle, adopting a fully unhedged mandate exposes investors to the high volatility of local currency markets. Studying the performance of non-U.S. developed government bonds versus the U.S. dollar shows that volatility in the currency markets is the primary driver of performance in a non-U.S. dollar fixed-income portfolio. The good news, however, is that currency risk isn’t an all-or-nothing proposition. By actively managing currency risk, investors have the potential to add alpha by taking advantage of these swings, while also gaining the diversification benefits of an unhedged global portfolio.
The second wave of global multi-sector fixed-income investing
A global multi-sector approach is one type of solution that is uniquely capable of navigating an uncertain market environment, helping investors capture interest-rate, credit, and currency opportunities in a risk-conscious manner. By expanding the opportunity set of the mandate, investors are able to gain exposure across geographic regions, countries, sectors, currencies, and credit quality while adding a layer of diversification away from domestic interest-rate and/or inflation risk. This approach not only has the potential to increase the yield and return profile of a fixed-income allocation, but also to increase the risk efficiency of an allocation by combining sectors that aren’t historically highly correlated. For example, over the past 10 years, eVestment’s Global Multi-Sector Fixed Income Universe has achieved median returns of approximately 4.1% with 4.9% volatility. With active management, this creates the opportunity to further increase returns and/or reduce volatility.
Markets move fast, particularly when it comes to “plus” sectors such as high-yield and emerging-market debt, which often experience higher volatility and lower liquidity. Global multi-sector fixed-income mandates give the manager the flexibility to rotate a portfolio in real time as markets dislocate, targeting potential opportunities without the need to go through the lengthy onboarding process institutional investors are frequently subject to. Ultimately, by hiring a global multi-sector fixed-income manager, investors are able speed up the decision-making process while adding a layer of diversification relative to their own top-down decisions and the resulting sector allocations. We believe this is of heightened importance in today’s fixed-income landscape, defined by high inflation and economic uncertainty; conventional, quality-focused bond strategies may no longer be able to provide sufficient income generation or tail-risk protection to meet investors’ risk/return objectives.
Rather, we believe that success in a today’s challenging market environment demands a more balanced approach to the risk/reward trade-off within fixed income. Global multi-sector fixed-income managers can pursue dislocations as they occur and take steps to protect the portfolio by dialing down risk in anticipation of heightened volatility. Subsequently, such a strategy should see its correlation to various asset classes and sectors to change over time, with greater sensitivity to riskier assets in risk-on environments and reduced correlation in risk-off environments.
Another factor we believe makes global multi-sector mandates attractive is today’s increased bond market volatility. Global economic uncertainties, along with tighter monetary policy from a number of central banks, have contributed to a major increase in fixed-income volatility. Rather than ride the highs and lows of a static benchmark-oriented allocation, global multi-sector strategies can seek out the best parts of the market and, as importantly, avoid altogether those parts of the market that present the most risk. Investors are increasingly seeing value in these types of strategies, which, when executed appropriately, can deliver a risk profile consistent with that of a traditional fixed-income mandate, while offering the potential to participate in up markets and rotating to protect capital in volatile markets.
Global Treasury ex-U.S. is represented by the Bloomberg Global Treasury ex-U.S. Index, which tracks the performance of fixed-rate local currency sovereign debt of investment-grade countries outside the United States.
Global Credit–Corporate is represented by the Bloomberg Global Aggregate Credit–Corporate Investment-Grade (IG) Index, which tracks the performance of IG, U.S. dollar-denominated, fixed-rate, taxable corporate bond market.
EM Local Currency Sovereign is represented by the Bloomberg Emerging Markets (EM) Local Currency Sovereign Bond Index, which tracks the performance of local currency sovereign debt issued by emerging-market countries.
EM USD Aggregate is represented by the Bloomberg Emerging Markets (EM) U.S. Dollar (USD) Aggregate Bond Index, which tracks the performance of USD-denominated debt from sovereign, quasisovereign, and corporate EM issuers.
EM USD Aggregate: Corporate is represented by the Bloomberg Emerging Markets (EM) U.S. Dollar (USD) Aggregate Bond Index Corporate, which tracks the performance of USD-denominated debt from corporate EM issuers.
U.S. Asset-Backed Securities is represented by the Bloomberg U.S. Asset-Backed Securities (ABS) Index, which tracks the performance of three subsectors—credit and charge cards, autos, and utilities. The index includes pass-through, bullet, and controlled amortization structures.
U.S. Investment Grade CMBS is represented by the Bloomberg U.S. CMBS Investment Grade Index, which tracks the performance of U.S. agency and U.S. non-agency conduit and fusion CMBS deals with a minimum current deal size of $300M.
U.S. Treasury is represented by the Bloomberg U.S. Treasury Index, which tracks U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index.
U.S. Corporate Investment Grade is represented by the Bloomberg U.S. Corporate Investment Grade Index, which tracks the investment-grade, fixed-rate, taxable corporate bond market.
U.S. MBS: Agency Fixed Rate is represented by the Bloomberg U.S. Mortgage-Backed Securities (MBS) Index, which tracks the 15- and 30-year fixed-rate securities backed by the mortgage pools of Ginnie Mae, Freddie Mac, and Fannie Mae.
U.S. Corporate High Yield is represented by the Bloomberg U.S. Corporate High Yield Bond Index, which tracks the performance of the U.S. dollar-denominated, high-yield, fixed-rate corporate bond market.
The Bloomberg U.S. Aggregate Bond Index tracks the performance of U.S. investment-grade bonds in government, asset-backed, and corporate debt markets.
The Bloomberg U.S. Aggregate Government Index tracks the performance of U.S. dollar-denominated fixed-rate, nominal U.S. Treasuries and U.S. agency debentures.
The Bloomberg Pan-European Aggregate Index tracks fixed-rate, investment-grade securities issued in European currencies. Inclusion is based on the currency of the issue, and not the domicile of the issuer.
The Bloomberg Asian-Pacific Aggregate Index tracks the performance of Asia-Pacific fixed-rate, investment-grade securities and is composed primarily of local currency sovereign and government-related debt, as well as corporate and securitized bonds.
The Intercontinental Exchange (ICE) Bank of America (BofA) U.S. Corporate Index tracks the performance of U.S. dollar-denominated investment-grade corporate debt publicly issued in the U.S. domestic market.
The Intercontinental Exchange (ICE) Bank of America (BofA) Global High Yield Index tracks the performance of below investment-grade corporate debt of issuers domiciled in countries with an investment-grade foreign currency long-term debt rating.
The Credit Suisse Leveraged Loan Index tracks the U.S. dollar-denominated, non-investment-grade leveraged loan market.
The J.P. Morgan Emerging Markets Bond Index (EMBI) Global Diversified Index tracks the performance of U.S. dollar-denominated Brady bonds, Eurobonds, and traded loans issued by sovereign and quasisovereign entities, capping exposure to countries with larger amounts of outstanding debt.
The J.P. Morgan Government Bond Index Emerging Markets (GBI-EM) Global Diversified Index tracks the performance of local currency-denominated, fixed-rate government debt issued in emerging markets, capping exposure to countries with larger amounts of outstanding debt.
The FTSE 3-Month U.S. Treasury Bill Index tracks the performance of the most recent three-month U.S. Treasury bill issues.
It is not possible to invest directly in an index.
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