Inflation and labour markets have remained stubborn for some time, causing many major central banks to delay the start of their monetary easing cycles. However, there are signs that these key measures are beginning to ease, which paves the way for fixed income markets to deliver attractive risk-adjusted returns. We believe a strategy with an active approach to investing across the global fixed income spectrum is best placed to capitalise on the opportunities that could emerge as the tide turns for the asset class.
Is it too late to invest in fixed income?
It is a natural concern for investors to think they’ve missed the fixed income train given how far credit spreads have compressed already. Spreads are at multi-year tights, and there feels like little room for them to compress any further.
However, while spreads may offer less upside potential, all-in yields across nearly all major fixed income sectors remain well above 2022 yields. Therefore, investors still have time to lock in these yields as central banks embark on their cutting cycles.
It was also promising to see correlations between government bonds and equities have now moved to neutral or negative, having previously been positive in the high inflation environment. Bonds once again offer investors diversification, which is particularly important in a multi-asset context should equities encounter volatility going forward.
The high current yield levels are especially important given starting yields are historically a strong predictor for future annualised returns over the following five years. The current yield-to-worst on the Bloomberg Global Aggregate Total Return Index of nearly 4% implies over a 4-8% annualised return in the subsequent five years. Income-seeking investors now have an alternative source of yield in core fixed income as money market yields decline.
So what about spreads?
There is no escaping the fact that spreads are not cheap. A resilient consumer and strong corporate balance sheets have meant that investment grade and high yield spreads continued to grind tighter to levels not seen since 2021. However, given our base case scenario for the US economy is a soft landing, historical analysis suggests that credit spreads can tighten further from here. From both the top-down and bottom-up, we are seeing reassuring signs that credit markets remain healthy, which supports being overweight versus our benchmark.
Positioning for a soft landing scenario
We continue to see attractive opportunities across the global fixed income landscape. We believe a strategy with an active approach to investing across the global fixed income spectrum is best placed to exploit risks and opportunities as we enter what could be an exciting period for fixed income investors.
Our JPM Global Aggregate Bond Active UCITS ETF – an active core bond allocation launched in October 2023 – we believe is positioned to capture two key macroeconomic themes that we think will play out in the coming months: an interest rate cutting cycle by most major central banks, and a soft landing for economic growth. This means the portfolio has a diversified basket of curve steepeners as well as sectors that offer greater carry, such as investment grade credit, mortgage backed securities and European peripheral debt.
As central banks cut rates in a soft landing scenario, we can expect the curve to steepen further as front-end yields decline. We think an effective way of capturing this move is via steepeners. The steepener trade also acts as a recessionary hedge to the riskier parts of the portfolio should a recession occur. In this scenario, the Federal Reserve’s cutting cycle will need to be more aggressive than currently priced, and the curve can steepen by an even greater extent.
Within credit markets, we continue to favour overweight positions in investment grade assets. Although investment grade spreads are relatively compressed, all-in yields remain above longer-term averages.
From a technical perspective, supply and demand in primary issuance markets has been strong, providing further support to the asset class. Meanwhile, from the bottom-up, corporate earnings also continue to look robust. A strong fundamental and technical backdrop means that we continue to think spreads can grind tighter going forward, while current yields provide an attractive entry point for investors looking to increase their investment grade exposure.
However, the portfolio remains well poised for a multitude of scenarios. Our barbell approach to holding credit risk as well as curve steepeners means that if a soft landing isn’t realised, our risks are diversified and we can hedge against the possibility of a recession. So the JPM Global Aggregate Bond Active UCITS ETF1 is well positioned we feel to benefit from a soft landing scenario, with the added protection of curve steepeners should we enter a recessionary environment.