A Multi-Asset perspective on fixed income investing in a future of lower interest rates
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Article Type
Market Updates
Topic
Multi-Asset
Published
October 15, 2024
Read time
5 mins
Author
Debbie King
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As multi asset investors, we believe investing through an income lens provides stability to portfolio returns. Income is tangible, contractual and delivery occurs regardless of the phases of economic cycles, unlike capital upside or growth from investing, the timing of which is often uncertain.  To that end, the income we gather from our exposure to bonds is an important part of our portfolio construction; it provides a defensive buffer to investment returns in periods of drawdown and a supportive foundation for positive total returns in periods of growth.

 

As developed markets’ interest rates reduce from peak levels the interest rate exposure of our fund’s fixed income selection, its duration, is an important consideration. Much has been written about the technical support expected in fixed income markets from flows that leave money market funds as interest rates drops.  Bonds are most definitely back in fashion, but not all bonds are created equal.

 

In our contrarian view, longer dated developed market government bonds offer little absolute value at current levels.  This view holds that yields don’t reflect the current situation, that the most likely outcome is a muddling through of acceptable economic levels, inflation and growth, with no recession.  With German 10-year government offering a yield of 2.2%, the UK 4.2% and the US around 4.0%, we believe the market has already priced in many of the cuts likely to be realised over the next 12 months as policy makers return to an environment of more normalised policy rates.  We do not envisage a return to emergency rate levels in the near future.  Should our base case ‘soft landing’ scenario change we would likely reduce our equity exposure to protect the portfolio rather than buy long dated government bonds where positioning is already crowded. The best course of action must always be to sell the asset class with highest drawdown potential and where concerns are highest.

 

We currently favour credit within the fixed income allocation of the Aegon Diversified Monthly Income Fund and expect the majority of returns to come from carry rather than spread tightening or a duration rally.  With longer dated government bond yields at low levels, future returns from investment grade bonds are essentially limited to the low to mid-single digit yields currently available and we have reduced exposure to this area. 

 

High yield returns in comparison benefit from a starting yield of 7-8% which offers a more useful level of income and better risk/reward. Mixed global growth is offset by a supportive technical backdrop, the fundamentals and corporate earnings are largely supportive and, whilst idiosyncratic risk is rising, default forecasts remain manageable.  However, it is a finely balanced act and as such we are firmly focused on quality. We believe this is achieved through targeting investments in enduring businesses with sustainable income streams and viable balance sheets. We have tilted our portfolio towards selected areas of markets that we believe offer value on a relative basis.  We remain focused on relatively shorter duration assets, where interest rate volatility will have a lesser effect and paradoxically investors are being paid more for lending over shorter timeframes: the sweet spot is quality BB and single B in high yield.  We have limited exposure to CCC rated issues however and are selective over structurally challenged sectors as we believe excess credit risk is likely to be punished by the market. 

 

In addition, we maintain a long-held preference toward subordinated financials with a positive view on the regulatory backdrop which has meaningfully repaired balance sheets post the global financial crisis.  We are cognisant of the higher beta nature of the AT1 asset class (and its inherent extension risk) but believe we are being appropriately compensated for those risks at current levels.

 

Of course, in multi asset we don’t simply look at credit markets relative to government debt, our asset allocation is driven by our total return and risk expectations for an asset class and their attractiveness relative to all our asset class opportunities, including equities, alternatives and opportunities in currency markets.

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Author

Debbie King
Portfolio Manager

Debbie King, investment manager, is a member of the multi-asset group. She is the co-manager of the Diversified Monthly Income fund and co-manages our multi asset white label product offerings. 

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