Fixed income: Managing inflation risk
- The effectiveness of monetary and fiscal policy in responding to COVID-19 has created a credible risk that bond investors have not faced for many years—higher inflation.
- The rise in core government bond yields from a low starting point limits the appeal of owning these assets in the near term, but they remain a key source of diversification within portfolios. Credit and EM debt can still offer an income solution.
- Investors may wish to consider a dynamic allocation to fixed income markets so as to remain nimble to traverse the uncertainties of the bond market.
- The chart shows the yields available across the fixed income spectrum. Yields on DM government bonds have started to rise from an exceptionally low level, while the search for income has kept yields low in other sectors.
- Investors will have to look across the higher yielding end of EM bonds for income. However, they will need to remain mindful of the risk of inflation and higher UST yields and work to manage that risk.
Don’t fear inflation
The effectiveness of the 2020 policy response to the COVID-19 pandemic has created an inflation risk that bond investors have not faced for many years.
- In the years after the global financial crisis, the extraordinary policies of central banks failed to create inflation, but helped to avoid persistent deflation.
- Now, the combined effect of coordinated monetary and fiscal policies changes the narrative, with higher inflation being a real risk.
- A risk does not need to be feared, but does need to be managed. Being short duration rather than long means bond holders can re-invest at higher yields. Tilting towards credit over government debt also means investors can use the positive inflation environment to their advantage as corporate fundamentals improve and credit risk declines.
- This chart shows the spread-to-worst across DM credit markets and EM bonds. The lower the spread, the more expensive the market.
- Across the credit spectrum, spreads have fallen back toward their lows prior to the pandemic.
The support of both the government and the Fed led to a sharp retracing in spreads, with U.S. IG credit spreads back at their pre-COVID-19 levels by January 2021. Many other segments of the credit market experienced a similar, but less dramatic, market movement.
- Further narrowing in credit spreads is unlikely and, as such, coupons will make up a greater proportion of returns. This suggests allocating to the segments of the market with the highest yield, namely EM debt and the higher beta parts of the HY bond market.
- Improving corporate health and earnings recovery is supportive of credit markets in the same way it supports equities, minimizing the potential for significant spread widening.
- Investors will have to be mindful of the impact of rising UST yields and may opt for a more dynamic approach to fixed income markets as yields rise.
- The chart illustrates the relationship between bond yields and the correlation to equity markets.
- The trade-off of moving up the risk spectrum in fixed income markets is a lower level of diversification against equity markets and increasing correlation to equities.
- Core government bonds still have a role as a diversifier in a portfolio, albeit a more costly one.
Owning government bonds has been relatively unappealing with the low level of income and high valuations. But rising yields may change this dynamic.
- The early stages of the rise in bond yields imply large capital losses when yields are low. But as yields rise, investors may start to rotate back into government bonds.
- The relative valuations argument to equities and other risk assets could start to narrow, and investors who have benefited from rising equities over the last year may wish to rebalance their portfolios.
- This rebalancing may actually cap, or at least stem, some of the rise in bond yields, limiting the potential for losses. However, the rotation may not gain momentum until there is more clarity on the strength of the rebound and central banks’ responses.
- Rising inflation is traditionally the enemy of the bond investor, and rising yields certainly limit the appeal of longer duration fixed income assets in the near term.
- With uncertainty over how persistent the inflation threat will be, or how fast and high core government bond yields may go, investors should take a dynamic approach to bond markets, allowing for a shifting fixed income allocation across fixed income segments.
- Positioning in shorter duration assets limits the impact of the inflation risk and allows for re-investment amid better valuations as yields rise.
- The rise in yields will likely come in waves, but eventually bond yields will reach a level where they are once again appealing for both portfolio income and diversification.