What do you want from your Fixed Interest allocation

It is often difficult to get investors excited about fixed income. Equity markets tend to have simple and appealing narratives to whet investor appetites, their potential returns are much higher and we have lived through a golden age of equity investing where the war stories and total losses have either failed to materialise or have been drowned out by a cacophony of HODLers, rocket emojis and 10-baggers. To make matters worse - for much of the post-crisis period fixed income wasn’t even paying much income. It’s no wonder that investors largely tuned out.

Fixed income rarely even pretends to compete with equity market dynamics, and rightly so, but there are certainly some characteristics of the more sedate bond market which can, and do, appeal to investors.

Largely these can be summarised as income, diversification and safety. As intimated above these characteristics are not necessarily inherent – we have lived through a zero or even negative interest rate experiment whereby tens of trillions of pounds’ worth of bonds traded with a negative yield. The rise of inflation in the post-pandemic era has seen the correlation between stocks and bonds turn positive – far from diversifying your exposure fixed income was doubling down on losses from equities. Even the safety of bonds has been challenged – the mark to market losses on the safest of all safe assets – US Treasuries has been large enough to generate the second, third and fourth largest US bank collapses in history (First Republic, Silicon Valley and Signature respectively…Washington Mutual retains top spot).

That is the past, but in the world of investing we must look to the future. So, what can investors expect to happen next and thus what might they seek from their bond allocation looking ahead?

First and foremost, it is plainly the case that fixed income once again offers a competitive yield. The chart below, using data from the US, shows that as bond yields have risen there has been a commensurate fall in the earnings yield (the inverse of the price to earnings ratio i.e. E/P) of equities (in this case the major US index the S&P 500).

Bonds can compete

As a result, and for the first time since the early 2000s, bond yields are in line with the yield on earnings. Opinions differ on the best method of calculating the equity risk premium (ERP – the additional return investors demand to invest in the riskier equity market), but one valid methodology involves using the earnings yield as a proxy for long-term expected equity returns. Under that approach the ERP is currently 0 i.e. there is no additional expected return to compensate investors for investing in riskier and more volatile equity markets.

It is plainly the case that the rise in inflation, and subsequent actions of central banks to deal with it, have presented today’s opportunities across fixed income markets. Of course, how attractive these opportunities turn out to be will, to a significant degree, hinge on future inflation outcomes and the resulting actions of central banks.

Without getting drawn into a detailed analysis of inflation (we will be publishing on that topic soon) it is abundantly clear from the below chart that UK inflation has been on a journey and the destination thus far is for price pressures to very broadly return to where they have been in the post crisis era. For all the talk of sticky inflation and the need for further monetary tightening by many measures we experienced higher inflation in the 2010-2011 period when rates were near zero and the Bank of England sat on its hands. If the medium-term trend continues, as the Bank itself forecasts that it will, then rate cuts, rather than rate hikes, will be on the agenda.

Inflation is headed in the right direction

That outlook is the Bank of England’s base case, and it doesn’t involve a recession of any kind. If we throw a recession into the mix (it would be near-unprecedented for us to not experience a recession given the starting point of low but rising unemployment, anaemic GDP growth and a large pro-cyclical fiscal deficit hot on the heels of an aggressive tightening of monetary policy) the outlook for inflation and interest rates looks markedly more downward sloping. That means the return outlook for bonds would be significantly more appealing driven by capital gains, on top of income, as bond prices would rise commensurately with the fall in interest rates.

Of course, nothing is a sure thing and there will be many readers expecting a softer landing for the economy rather than a recession (see our piece on unemployment and the cycle for one key reason we are sceptical). In such a scenario core bond yields might not fall but bond owners would still be receiving a solid income and those invested in higher yielding debt issued by high quality corporations would be earning a nice spread on top of those core yields.

Therein lies the rub. Fixed income is a broad church. From government bonds to high yield credit to emerging markets, from short duration to long duration to highly flexible strategic bond or total return funds there are products which cater to a range of tastes, outlooks and risk tolerances. Its important to understand what you are buying and why that choice might be appropriate. In a strategic bond fund, you may find that you own a fixed income product which doesn’t achieve significant returns during an economic downturn because the manager either owns a lot of risky credit or has significantly reduced duration or both. In a US corporate bond fund, you may suffer because spread widening negates the returns from falling yields or because the US dollar weakens materially against your home currency and that negates the positive returns from falling yields or tightening spreads. One thing we would remind investors above all is that diversification is not a dirty word. A fixed income fund which has significant duration, significant high quality corporate risk and a globally diversified portfolio of bonds in a variety of currencies allows investors to earn attractive income, participate in capital gains if the economy hits the skids but still achieve solid returns if doesn’t. Now is the time for the global bond fund to shine.

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This article is provided for general information purposes only and should not be construed as personal financial advice to invest in any fund or product. These are the investment manager’s views at the time of writing and should not be construed as investment advice. The opinions expressed are correct at time of writing and may be subject to change. Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds.