3Q 2021 bonds: themes and opportunities in an inflationary world
Looking at 3Q 2021, we seek out the fixed income opportunities as inflation sets in.
Interest rates have stayed low for longer and traditional income sources such as government bonds are yielding far less than inflation1, prompting some investors to look for more attractive income prospects2.
Inflation remains a key focus, notably in the US, with a growing view that tight supply chains, semiconductor shortages, higher commodity prices and falling jobless rates could push consumer price indices higher. In Australia, the core rate of inflation was 1.1% year-over-year, as of March 20211. Inflation has been picking up in the US where the core rate was 2.6% in March 2021, rising to 4.2% in April and stood at 5.0% in May4.
The Federal Reserve’s more optimistic view on US economic growth and inflation in 20215 should prompt a reduction in asset purchases in 2022, followed by rate hikes in 20236. The Reserve Bank of Australia has indicated it isn’t in a hurry to raise rates7.
Still, investors continue to seek high-grade and high-yield allocation ideas. In today’s environment, it’s crucial to employ an unconstrained and flexible approach to differentiate and invest where opportunities can be found.
Generally, bonds diversify portfolios as they exhibit low correlation to equities8. There are various types of bonds globally and they react differently to market changes, such as interest rate movements and the economic cycle.
An unconstrained approach can help identify the high-conviction investing ideas for a diversified fixed income portfolio.
As market conditions evolve, allocating across the full fixed income spectrum - traditional assets such as government and investment-grade (IG) bonds as well as non-traditional assets such as mortgage-backed securities (MBS) and high-yield (HY) corporate bonds - can help build a resilient and diversified portfolio.
For example, securitised debt such as agency MBS has exhibited uncorrelated returns to risk assets and could act as a hedge to portfolios8. Agency securitised debt is issued or guaranteed by US government-related bodies. They demonstrate defensive characteristics and could be considered as an alternative to US Treasuries. US MBS have also demonstrated lower volatility.
HY corporate debt and emerging market (EM) fixed income can also help provide some diversification benefits to a portfolio given their higher correlation with equities and risk assets.
Investors should consider how they allocate to each fixed income market segment as the difference in drivers of return, sensitivity to interest rate movements and corporate fundamentals will affect returns. Having the flexibility to move between sectors may be advantageous.
2. Seek out yield
Heightened inflation expectations can create risks for holders of core government bonds or longer duration assets. Fixed income investing could become more challenging with the potential price decline from duration risk. Developed market government bonds and IG corporate debt, with their low yields9, could face headwinds.
A range of fixed income yields9
Despite the recent higher-than-expected inflation numbers from the US and Australia, inflation is normal for a recovering and growing global economy, and likely transitory.
That said, a strengthening recovery has bolstered the earnings outlook. Profit margins have been improving and should lead to higher earnings and performance.
To take advantage of the current return potential, we believe opportunities exist in the higher beta parts of the credit spectrum, where duration is less of a concern. We are seeing improving corporate fundamentals, coupled with a default rate that peaked in late 2020. The overall quality of the market has improved.
Additionally, a strong recovery in the US would also bring along emerging economies levered to US growth, presenting opportunities for local EM debt9 and EM currencies.
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J.P. Morgan Asset Management employs a diversification framework that spans the entire fixed income universe. Every stage and component of the triangle can contribute to your portfolio's risk-adjusted returns.