This year is the first time in nearly a decade that bond investors have seen significant negative returns.In part, the sell-off in bonds was the result of the fading coronavirus risks and a robust economic recovery, and in part the consequence of elevated inflation risk and the potential removal of highly accommodative monetary policy. In principle, our forecasts for next year imply that yields, especially on longer durations, are likely to turn negative again.

With the pandemic largely behind us, interest rate markets next year will likely be driven by inflation outcomes and how central banks choose to respond.These considerations will need to be weighed alongside the decline in labor market slack, which, all else being equal, implies higher equilibrium yield levels.

While we do not expect very aggressive rate hikes next year from the major DM central banks (particularly the Fed and the ECB), high inflation and strong growth will likely allow markets to anticipate this exit, and yields should rise. Yields are therefore likely to remain a source of downward pressure on sovereign bond markets, as they were in the second half of this year.

With this backdrop, let's move on to the strategy.

When structuring a fixed income strategy, there are key variables to consider: credit risk and spread levels, interest rate trajectory, duration risk, and liquidity.

The current environment is particularly challenging for an RFI portfolio and more conservative risk profiles. Interest rates are at historic lows (therefore, rate risk is asymmetric), the duration of IG fixed income is at highs above 8 years (therefore, duration risk is very high), and corporate spreads are at near historic lows (offering little cushion to protect against rate hikes).

In particular, we do not see much risk of spreads widening going forward given the positive macro environment, positive corporate outlook, and increased risk appetite. Therefore, maintaining exposure to high-yield (HY) debt remains a good alternative, given its short duration. EM debt may be an alternative, but with considerably higher risk, given the prospects of deteriorating macro-financial conditions in China and higher inflation risks.

We also believe that the prospect of low yields will continue to stimulate appetite for illiquid segments, such as private debt markets, as well as for more complex instruments, such as structured products.

Investment decline

But what if I don't want to sacrifice liquidity and don't want to be exposed to the higher volatility of HY and EM debt?

Fortunately, there are now active, globally diversified strategies on the market that are flexible in terms of duration, seek to maximize income with a limited level of risk, and aim to pay out predictable dividend income.

In simple terms, they offer attractive returns with lower volatility than individual sectors and predictable distributions.

These strategies basically invest in all types of fixed income. They include government bonds, credit (IG and HY), EMD, and securitized debt, but liquid and very short-term, which is what allows for predictable coupons, in addition to being floating-rate debt.

Within this universe of strategies, we highlight two funds:

PIMCO GIS Income Fund and JPM Income Fund

The first is a strategy that has delivered on its objectives for more than a decade: seeking value in the global fixed income market while balancing return with capital preservation objectives.

• A multi-sector approach with the flexibility to invest across the entire $110 trillion bond market.
• Allocate between higher-yielding and higher-quality assets in order to provide consistent and diversified sources of return.
• Emphasize risk management and a "bend but don't break" credit philosophy to withstand market volatility.
• The fund has a flexible duration ranging from 0 to 8 years, can hold a maximum of 50% in HY debt, a maximum of 20% in EM debt, and a maximum exposure of 30% to FX.

Currently, the fund has a duration of 1.6 years and a YTM of 3.6%, accumulating a return of 1.42% for the year (at the end of October), 6% over 12 months, and an annualized return of 5.3% over three years.

The second strategy uses an investment process driven by a globally integrated research process that focuses on analyzing fundamental, quantitative, and technical factors across all countries, sectors, and issuers.

• It uses an unrestricted approach to find the best investment ideas across multiple sectors and fixed income countries with a focus on generating consistent income distribution.
• Dynamically switch between sectors and countries and adjust the duration depending on market conditions.
• Revenues are managed to minimize fluctuations in periodic dividend payments.
• The fund has a risk target of 4-6% volatility and, in terms of credit quality, a maximum of 65% below IG. 

The fund currently has a duration of 1.2 years and a YTM of 3.6%, with a return of 2.8% for the year (at the end of October), 6% over 12 months, and an annualized return of 5.5% over three years.

 

Humberto Mora

Strategy and Investments