Fixed income is back in fashion, competing as an alternative investment to traditionally higher yielding riskier assets from a return perspective, as opposed to just portfolio diversification.
It’s had a rocky journey to this point, of course.
After more than a decade of low yields for income investments, global bond yields began to reverse course in 2021 as the market anticipated higher inflation in response to the huge monetary stimulus during the pandemic.
This trend accelerated with the Ukraine conflict as commodity prices spiked and supply chains became constrained.
And when the Kwarteng/Truss mini-Budget of autumn 2022 brought about a UK government fiscal credibility crisis, domestic gilt yields positively surged. They have remained elevated, with gilt yields now at levels last seen in the 1990s/early 2000s, as inflation fears proved correct and expansionary fiscal policy led to a significant increase in bond issuance.
Now the interest rate landscape is far more attractive for those looking for a return from bonds. Government bonds and high-quality credit will be a natural beneficiary when we experience bouts of volatility as economic growth slows.
Medium-dated gilts now yield 4.5%. With inflation metrics slowing and bond volatility falling, gilts are appealing, with index-linked bonds – where price and coupons are linked to inflation – looking particularly compelling with a real yield above 1%. Credit spreads over government bonds have widened as yields have increased, leading other fixed income sectors to offer attractive valuations for their risk profile.
We are cautiously optimistic on investment grade debt. The rise in absolute yield levels provides an income buffer though not total protection against a sell-off in an economic slowdown. Weaker growth is likely to weigh on corporate profit margins and cashflows but yields of around 6% on sterling investment grade credit provide a healthy cushion to any further spread widening.
Emerging market sovereign debt looks interesting at current spreads of more than 4% to US treasuries as the average subsequent 12 month return when spreads get to this level is more than 10% for hard currency bonds.
The market does face the headwinds of slowing developed market growth and weakness in China, but the US dollar will likely stabilise as Fed Funds are close to their peak, while inflation is declining quicker than in developed markets.
Higher yields provide less comfort on high-yield debt, however. Such companies tend to have greater leverage, lack pricing power, run on thinner margins and cash buffers, and face a higher wall of maturities. This could prove problematic over the near term.
What this means for the LGPS
Though the profile of fixed income appeals to long term investors, LGPS funds have historically held modest allocations due to a lack of liability driven reasons for doing so. Without an attractive return profile versus other asset classes, there was little appetite for fixed income.
With the improved funding level of, and greater need for cashflow in, the LGPS over recent years, there is scope to increase holdings at higher rates and higher funding levels.
Looking ahead
Economic sentiment is weakening and forward-looking measures of activity, such as money supply, are falling, while inflation has pulled back from its high and is expected to gravitate back to 2% over the medium term.
The major central banks are communicating that official interest rates are at or near the peak and financial markets are pricing in rate cuts next year.
Though yields are likely to remain elevated for a while, and bouts of volatility should be expected – perhaps in response to geopolitical events – we believe the market has priced in sufficient risk premia and yields will move off their highs in the not-too-distant future.
While the economic landscape is subject to change, as a long-term investor, we believe bonds, including those that are inflation linked, currently provide ‘a two birds with one stone’ opportunity; generating attractive income and also helping to match a portion of liabilities.
Daniel Loughney is a fixed income portfolio manager at Border to Coast
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