What should bond investors do in different environments?

Falling rates? Rising opportunities?

What do lower interest rates mean for you?

As inflation pressures start to ease, expectations of cuts in interest rates have grown. Bond prices typically rise when interest rates fall. This means that bonds have become more attractive for investors seeking a consistent real income as inflationary pressures lessen. 

So where should you be positioned?

We think bonds with a greater sensitivity to interest rate changes can be compelling in an environment when interest rates decline. Optimal Income strategy is completely flexible in how its positioned in order to capture what we believe is the best value for our investors. Using the full resources of our research team, we are constantly changing positions along the so-called bond yield curve. This might mean holding more longer-dated government bonds (they have a greater sensitivity to interest rate movements) compared to short-dated government bonds. 

On the other hand, an environment of falling interest rates and lower inflation, but weaker global economic activity, means we want to be cautious on holding too many corporate bonds. We think many bonds in this area are overpriced considering the backdrop for the economy is weak. 

Slowing economy? Time to be active

How do bonds behave when growth slows?

The direction of bond markets is anything but straightforward when the economy slows down. Added to this, other uncertainties on a whole range of issues (the timing of any interest rates cuts, inflation data, even geopolitics) can make some types of bonds unattractive, while other areas of fixed income can appear appealing.

But we can help here: We can actively seek to capture any price opportunities that arise because we can be flexible across different markets and regions. We are also not forced to invest in a particular area – our investment mandate is highly flexible in this regard.

If a recession were to occur, a slight fall in interest rates would likely have a small impact on stimulating the economy, unfortunately. A more substantial intervention would be necessary, potentially causing bond yields to decline more than anticipated. This would mean bond prices may rise more than expected and we therefore believe that bonds still hold value even in the event of a recession. 

Is there value in corporate bonds?

A weak economy doesn’t mean we sell out of corporate bonds and just ‘sit in’ safer government bonds until things improve. We can be very selective and identify some corporate bonds that our research analysts calculate are fair or good value. This can be in bonds issued by the same company, but yet have with different characteristics (i.e. bonds with different time horizons, or bonds issued in different currencies). But, all things equal, a weaker economy will lead us to go up in quality within the bonds that we hold.

Cash is King?

Not anymore and here’s why…

As interest rates fall, the return on cash investments decreases, resulting in lower yields and diminished income generation. This reduced income potential is particularly notable for those who rely on income from their investments to cover living expenses or achieve financial goals.

With cash holdings, the income generated from interest or dividends may no longer provide the same level of sustenance or growth.

An Optimal alternate solution?

As central banks reduce interest rates, the returns on cash diminish, whereas government bonds can typically compensate for the diminishing returns through capital appreciation, resulting in a possible outperformance. While cash has its merits, it is important to recognise its limitations, particularly during a period of falling interest rates. Assessing the broader financial landscape and exploring alternative investment possibilities, such as Optimal Income strategy, may help ensure the preservation and growth of income for investors favouring cash.

Volatility! How do we respond?

Can diversification help?

Given the Optimal Income strategy began in 2006, we have experienced many different types of markets, economic environments and bumps in the road. We have argued for many years that the wide-ranging flexible nature of the strategy means it is possible to have a smoother investment journey. 

Crucially we have been able to adjust where we see opportunities. For instance, a cautious allocation to high yield bonds when the economic outlook is poor. On the flip side, having more government bonds can be helpful as a buffer against volatility. This is because the prices of these investments generally rises when markets get nervous, just like it did recently when the US realised its weak jobs data. 

Finally, when the market steadies, and the global economy improves, we have the tools to add more riskier investments– like increase holdings of high yield bonds or corporate bonds more generally.

Overall, it’s almost been two decades since Optimal Income strategy was launched. During this time, we believe having lots of flexibility – across duration and credit, and across global bond markets moreover – has been supportive of the strategy’s consistent, long-term investment performance.