Published in partnership with T. Rowe Price.

Fixed income has historically played a critical role in building portfolio resilience through stable income and yield diversification, but in the years during and immediately after COVID-19, when interest rates hovered at or near zero, bonds quietly faded into the background.

But as asset owners seek to manage growing portfolio risk, the focus is firmly on bonds again.

Participants at an Investment Magazine roundtable hosted in partnership with T. Rowe Price all agreed that fixed income investing had become more interesting in recent years, albeit increasingly complex, amidst higher inflation, rising fiscal deficits and broader, deeper credit markets.

Adam Marden, portfolio manager, fixed income at T. Rowe Price, described the current environment as a “bond bear market” caused by a reversing of “four big waves” of global disinflation: the rise of energy productivity, the opening up of emerging market capital accounts in the early 80s, the fall of the Berlin Wall in 1991 and China joining the World Trade Organisation in 1997.

“Those global disinflationary dividends effectively peaked in the mid-2010s and, also, during the post-GFC era, we saw both the largest absolute private deleveraging cycle in the US and the largest bank capital regulation cycle the world has ever seen,” he said.

“During that disinflationary period, there was a premium on things like operational and cost efficiency, and supply chain management, but now we’re seeing a premium on resilience across everything.”

According to Marden, investors won’t see the same capital appreciation they experienced during the 40-year disinflationary period, but they will see higher rates and better yields.

“You can still have positive returns in bear markets as experienced in the 70s for equities when multiples went down and prices stayed the same, but earnings and dividends went up,” he said.

“Investors didn’t actually lose money. It’s the same thing here. You’re not losing money, there’s just a lot of inertia, which is why customisation is important.”

Cassandra Crowe, head of institutional and consultant relations at T. Rowe Price, said there was a lot of interest in “activating fixed income” at this point in the economic cycle.

“A theme that keeps coming up in all our meetings is the need for portfolio resilience, and fixed interest can play a really important role here,” she said.

“We’re seeing different ways of tackling that with some asset owners looking to disaggregate the Agg and have specific allocations to say global government bonds or credit, and others taking a multi-sector type strategy.

“There’s also interest in emerging markets debt, which is not something we’ve seen for many years. There is no single solution for every client and it’s all about customisation.”

Jody Fitzgerald, general manager, defensive and liquid assets and portfolio intelligence at Australian Retirement Trust (ART), described portfolio resilience as the ability to “minimise drawdowns, maximise recoveries when they actually come and ensure appropriate levels of liquidity to discharge a fund’s obligations”.

To achieve those objectives, ART has established a portfolio resilience forum where key topics and ideas are presented, with the aim of giving the investment team a better understanding of where risk sits in the portfolio.

“It leads to interesting conversations about how we should be thinking about risk in terms of breaking a portfolio down into benchmarks and asset weights, or risk factors,” Fitzgerald said.    

Over the past few years, ART has been gradually moving to a total portfolio approach (TPA) as it looks to increase the sophistication of capital allocation decisions across the fund. “[That’s] important in the context of fixed interest,” Fitzgerald said.

“We’re not necessarily bound by the benchmark. The total portfolio management and resilience team effectively gives us a mandate. In short, they give us a benchmark and an outcome, and a fee budget and risk budget, and say, ‘over to you’. We have a very broad remit underneath that to construct a portfolio.”

Charles Wu, director of investments at Frontier Advisors, said the asset consultant was grappling with two main issues: firstly, the increasingly positive correlation between equities and fixed income, and secondly, rising fiscal deficits and structurally higher inflation.

“Yields are higher, which is fantastic, but there’s still uncertainty about the correlation between equities, which is on everybody’s mind,” he said.

“Post-2019 the numbers range from 0.6 to -0.5 so, from a portfolio construction perspective, if you have fixed income for its yield and defensive characteristics, it becomes a slightly different question when the correlation changes.”

Wu also questioned if rising government spending in areas like national security, AI and quantum computing required modelling a higher debt premium.

Similarly, Damien Webb, chief investment officer of Brighter Super, questioned if fixed income continued to be “true to label”, pointing out that the asset class had not provided the same level of “cushioning” during recent equity market downturns.

“Duration heavy fixed income is a very effective beta for the portfolio. If you’re looking for cheap, liquid beta, equities, bonds and cash are still in, so we need bonds to come to the party,” he said.                                                           

“With rates backing up to relatively attractive levels of yield, are investment grade bonds going to provide the buffer that’s on the tin, or are they still going to be a little bit funky? That is the question.”

When long-term inflation is above 3 per cent, the correlation between equities and bonds shifts from negative to positive, said Marden, citing a number of studies.

“If you have a long-term view that inflation is going to sniff around three or above, as I do, active management becomes critical,” he said.

“How then does fixed income fit in portfolios? It fits in for yield.”  

Chris Baker, senior portfolio manager, fixed income at AMP, agreed that active management was critical, particularly around sectors and duration, given the uncertainty around indebtedness and “bond vigilantes”.

“It’s all about coupons and income currently so we don’t want to deallocate out of fixed income despite the fact that many credit sectors are trading on more expensive given the tightness of credit spreads,” he said.

“We definitely have concerns around indebtedness and the way we factor that in is at the total portfolio level through resilience trade ideas, which could come in a number of trades including tactically buying gold or the implementation of duration options using credit derivatives to tactically hedge credit exposure at the margin to hedge market risk from time-to-time.”

“The main challenge is that the fixed income universe is so large, so deciding where to allocate capital requires numerous lenses to ultimately decide where to deploy. We believe there’s definitely a place for fixed income, which is why being active is important because it’s all very idiosyncratic and RV (relative value) focused and you want to make sure you’re being compensated (for risk).”

AMP is highly selective about where it utilises active management across its portfolio.

Baker described active management in credit as a “no brainer”, although the group has recently shifted from an enhanced index strategy for global aggregate bonds to a passive strategy that “uses collateral management and repos” to achieve similar alpha. 

At ART, “fiscal divergence” has made sovereign credit analysis more important, said Fitzgerald, adding that only 20 per cent of the fund’s sovereign bond allocation was passively managed.

“In the QE [quantitative easing] world, there was more or less one way to make money in bonds but now it’s a much harder decision so we are happy to run to active management in that space,” she said.

“We have an alpha target of 25 basis points over the sovereign bond benchmark and over the past three years we’ve delivered using active management, so the opportunities are there if you have the right partners.”

What looks good?

Within the fixed income opportunity set, Colonial First State is looking at high yield credit, emerging markets and floating rate credit, according to Robert Graham-Smith, the group’s head of fixed income and alternatives.

“There has been an upgrading of quality in the [high yield] benchmark over the past five years, and the all-in yields remain really strong,” he said.

“Obviously, spreads are tight and there are risks that come with that but, barring a train-wreck, we’re happy to harvest some of that.”

“If you have concerns about debt levels in developed markets, I think emerging markets are less reliant on US dollar denominated debt funding than the past, have grown up to some extent and some of the EM central banks are more street smart. We saw that in the last post-COVID rate cycle when inflation spiked, and some EM countries were really ahead of the curve versus history.”

Ron Mehmet, senior asset consultant at Evidentia Group, said changing market dynamics had created “better quality, better value” opportunities in high yield, as regulatory and structural changes led the banks and financial institutions to exit the middle market, pushing borrowers towards private credit.

Mehmet split high yield bonds into two buckets: “quality junk,” which is B and BB-rated, and “junk junk,” which is C to CCC-rated.

“A lot of the stuff in the C to CCC space in recent years has gone to private credit because they are giving better deals to companies issuing in that space and, as a result, the quality of remaining high yield issuers has improved over time,” Mehmet said.

“High yield is also very sensitive to economic growth so there’s the potential in the near term for B and BB-rated (securities) to upgrade in certain industries.”  

While Evidentia likes investment grade credit, it holds some concerns about global government bonds due to mounting fiscal deficits, trade deficit challenges and the “deterioration of both twin deficits the US”.

“There are a lot of good global and domestic blue-chip companies doing well on the IG (investment grade) side and the credit spreads in recent years have kept coming in, and there’s the potential that IG corporate credit looks more favourable than developed market government bonds,” Mehmet said.

For Evidentia, which builds portfolios primarily for retirees and pre-retirees, there’s a strong focus on income generation within performance as well as risk and volatility. Mehmet said the increasing breadth and depth of Australia’s corporate bond market, as more offshore companies issued corporate paper here, has provided additional attractive income opportunities for Evidentia’s client base.

Frontier Advisors’ Wu agreed that selected investment grade corporate credit currently looked “safer” than selected government bonds, which he said felt “weird” but “doesn’t mean you’re not taking on duration or credit risk though”.

“You’re getting a nice healthy spread for exactly the same thing but with less currency risk and more inflation-link,” he said.

“There’s uncertainty in every part of the curve now which is probably great for active management. As an investor, if I can get additional yield, and it’s potentially safer, why wouldn’t I make that trade-off?”

Bond bear market

Mehmet, a self-confessed “history buff”, pointed out that during the Great Depression of the 1930s to 1940s – a disinflationary period – the best-performing asset class was investment grade credit not gold or government bonds as many assume.

“There were a lot of defaults including sovereign too, but blue-chip investment grade credit sailed through that period and outperformed relative to other asset classes, providing income and returns throughout those decades,” he said.

“People always talk about risk and many move to government bonds because they think there’s less risk and volatility but that’s not necessarily true. There are always blue-chip companies that are durable and survive.”

One part of the market that particularly excites Marden is AI and new technologies, with AI hyperscaler expected CapEx in 2027 at $1.2 trillion. He believes it could increase to $1.6 trillion by the end of next year.

He acknowledged that this position may be contrarian to other fixed income investors, crediting T. Rowe Price’s global multi-asset class capabilities for providing a deeper, more balanced view of the investment universe.

“If you get a bunch of fixed income managers in a room it can be pretty depressing because everyone tends to think about the downside, which is why I believe that T. Rowe Price is a great macro shop because we have an equity platform to balance us with optimism,” Marden said.

“That’s actually why we’ve been short duration and long credit since 2020. We would not have gotten that call right without the view of both sides and the cross pollination of ideas. You need to have optimism to ride volatility.”

AI and hyperscalers are also on Graham-Smith’s radar at CFS.

“Obviously the benefit or opportunity cost of having exposure or not having exposure isn’t as big for fixed income investors as it is for equity investors, but it is something we are looking at because the issuance numbers are huge and although a lot of those companies have pristine balance sheets presently, we are focused on the sustainability of cited debt levels in the future,” he said.

“These companies are generating a tonne of cashflow but how do you think about this long term?”

For Marden, who chairs an investment forum at T. Rowe Price that includes portfolio managers across every asset class, the insight from the group’s equity managers is that the hyperscalers plan to spend every dollar they can get because they see revenue out of it.

“No one really knows how this will play out in the future, but when I think about the probability distribution of outcomes for the world, AI did not shift the base case, it just increased the tails,” he said.

“The right tail is a 3 per cent productivity driven real growth environment that’s going to last for some time, and the left tail is, we just set $3 trillion on fire. Right now, equity markets are pricing in the right tail, and fixed income markets continue to discuss the left tail. Those tails are just going to keep getting fatter over the next year.”