Navigating new waters

5 min read 14 May 24

Since 2006, the universe of investable bonds has experienced substantial growth, significantly enhancing the landscape of fixed income opportunities. This expansion offers investors a larger pool to consider, increasing the availability of diverse bonds in all parts of the world. More crucially, this growth has spurred deeper, more granular research into bond issuances, allowing for more informed investment decisions.

While this broadening of choices has its advantages, it also arrived during a challenging era characterized by prolonged periods of near-zero interest rates. Such an environment traditionally dampens the appeal of fixed income investments, as lower yields generally equate to reduced income potential for investors. The trade-off between increased investment options and the low-yield environment has been a balancing act—requiring more sophisticated strategies to capitalize on the nuances of the bond market.

However, recent shifts in the economic landscape are reshaping this dynamic. With yields having risen substantially, both in government and corporate bonds, the fixed income market is transitioning from a traditionally conservative asset class, used mainly for diversification, to a more compelling option for income and capital growth. Today’s higher yields present new avenues for income and appreciation, repositioning bonds as an exciting option for long-term investment portfolios. This shift not only reflects the inherent resilience of the fixed income market but also underscores its potential as a cornerstone in achieving balanced, growth-oriented investment outcomes.

Embracing long durations amidst economic shifts

The onset of the COVID-19 pandemic heralded significant changes in the global economic order, notably through the expansive monetary policies that led to a sharp increase in money supply. This initial response to the pandemic was pivotal in driving up inflation rates, sparking a cycle of economic reactions that continue to resonate. In response to the inflation surge, central banks reversed their earlier expansive policies by reducing liquidity, which has started to show efficacy as inflationary pressures begin to ease. We anticipate this trend will continue throughout the year, with inflation moving closer to target levels due to more restrictive monetary policies.

Despite these positive signs, the overall economic growth outlook remains complex. We are likely to see subdued growth, influenced by factors such as full employment, which can limit the expansion of the labor market, increased regulatory burdens, and higher levels of government intervention. These elements could naturally restrict economic dynamism. Contrary to this, the bond market's current pricing suggests expectations of higher growth, as reflected by real yields returning to pre-2008 levels. However, we believe that these rates should be lower to more accurately mirror the lower potential growth on the horizon.

Given this backdrop, we maintain an overweight and long duration positioning in many of our flexible  bond portfolios. Our assessment is that, despite the recent rise in nominal rates, there is still potential for yields to decrease further. Our strategy echoes our past approaches during similar periods of financial stress, such as in 2007-2008 and during the initial phases of the global financial crisis. We believe that a long duration stance not only protects against potential downside risks but also offers a favorable risk-reward trade-off, particularly in the case of core government bonds like U.S. Treasuries. The shift from the near-zero rates of the past, which offered limited upside and substantial downside, to a more balanced scenario today, supports our continued commitment to this strategic positioning.

A calculated approach to credit markets

In navigating the corporate bond landscape, we continue to employ a strategically neutral stance, albeit with a discerning eye on quality and maturity. Current valuations across the corporate bond sector appear generally fair, reflecting a business environment that anticipates positive, albeit subdued, economic growth. In line with this, our preference leans towards higher quality companies that issue bonds in the short-to-middle parts of the yield curve. This approach is designed to optimize returns while managing risk, as these segments typically offer a more attractive risk-reward balance compared to their longer-dated counterparts in our view.

Recently, we have adjusted our strategy in response to the considerable flattening of the credit yield curve, reducing our exposure to longer-dated corporate bonds. This decision is informed by the reduced yield premiums over shorter durations, which diminish the attractiveness of holding longer maturities amid rising interest rates and potential economic headwinds.

Sector-wise, our current focus has sharpened towards financials, particularly favoring the large European banks over their U.S. counterparts. This preference is grounded in several key factors: European banks generally exhibit lower leverage ratios, are subject to stronger regulatory oversight, and seem less affected by the challenges facing regional banks in the U.S. This selective approach within the financial sector aims to capitalize on regional stability and regulatory robustness, which we believe offer safer harbors in the current global economic climate.

Within the high-yield segment, we have been gradually reducing our positions since 2022-23. This trimming strategy follows strong performances from some holdings, rendering their current valuations somewhat stretched. Our portfolio reflects our cautious stance toward riskier assets amid market uncertainties - a calibrated reduction aligns with our broader strategy of prioritizing quality and sustainability over higher but potentially riskier yields. This careful management of our credit exposures ensures that we remain agile, ready to adjust to market shifts while safeguarding investments against undue volatility.

Preparing for tomorrow's challenges

In a financial landscape that has been reshaped by several years of ultra-low interest rates and recent shifts towards higher yields, our strategic adaptations are crafted to not just navigate but excel in these changing tides. Our long duration positioning and selectively cautious credit strategy are tailored to harness the opportunities presented by a maturing interest rate cycle while mitigating risks.

In addition, our vigilance in monitoring economic indicators and market trends ensures that our strategies are responsive and robust, poised to adapt to both challenges and opportunities. The potential for a "soft landing" in the economy, where inflation aligns with targets without triggering a recession, appears increasingly plausible. However, it is also important to be attentive to any potential deterioration in the growth outlook, and the risks of a policy mistake and inflation falling faster than what investors currently anticipate. We believe flexible bond strategies that exhibit a relatively elevated level of duration and a conservative positioning from a credit perspective can provide all these benefits. 

*This article was first published, in Chinese, in the Hong Kong Economic Journal.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. The views expressed in this document should not be taken as a recommendation, advice or forecast. Past performance is not a guide to future performance. 

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