Recent market movements have reminded investors that the fixed income market is facing a secular change, after a 30-year-long bull market driven by a continuous decline in interest rates. I believe the announcements of the death of fixed income as an asset class are greatly exaggerated, and in order to face the new reality, fixed income investors and asset allocators need to adopt a significant change of approach.
What about Fixed Income Investing? Bonds will probably always play a role in investors’ portfolios, but not in the same way as before. On one side, we still have long-term investors who need to match their long-dated liabilities. And the so-called “search for yield” that has characterized the retail demand for investment products in the last few years, is not destined to abate soon given the lack of income growth in the developed world. On the other side, fixed income investors, who collectively own more than $5 trillion in assets¹, are not used to capital losses after a 30-year bull market. Recent events have shown how violent the outflows from the asset class can be in phases of volatility.
Opportunities for Fixed Income Investors
Historic experience tells us that, even in long-term trends, interest rates do not move in a straight line, and there are short-term cyclical bull and bear market phases to exploit.
Options for fixed income investing include:
1. Importing “alternative investments” techniques in the mainstream investment space: risk budgeting and long/short investing in credit and global macro are the most obvious candidates.
2. Extending the scope of the fixed income asset class to a broader definition of income assets, which provide yield but are less correlated to the macro trends in interest rates and more to long-term structural trends: infrastructures and real estate.
3. Increasing portfolio leverage to seek better low fixed income returns (risk parity approach). An option we do not particularly like, due to its riskiness in case of adverse liquidity events.
Predictions for the Next Market Cycle
Fixed income aside, I don’t believe that the economic and financial landscape in the medium to long-term is particularly favorable for financial assets in general. The tailwinds of secular interest rate declines and credit expansion are not going to be there to help in the new cycle. For asset allocators, I believe it will be key to move from a liquidity-driven and central bank-dominated market interpretation, to one relying more on long-term scenario analysis; accepting and managing proactively, the hopefully short-term market volatility. Investors will need to be careful in their choice of a fixed income manager/advisor: they should be nimble and flexible, and aware of new investment techniques available to help them navigate stormy waters as smoothly as possible.