Embracing the Fixed Income Shift

A prudent move in the changing economic landscape.

By Attila KadikoyArticle originally posted here.

Fixed income investments involve a contractual agreement backed by assets and promise a specific yield over a set period. Image: AdobeStock
Since the 2008 Global Financial Crisis (GFC), we’ve witnessed an era of historically low interest rates, negligible inflation, and substantial liquidity offered by central banks. For the most part, this all persisted even after the Covid-19 pandemic.

While this environment was a necessary response to the GFC it left people vulnerable to the changes we are currently experiencing and the ‘normalisation’.

Individuals grew accustomed to low rates and almost expected inflation to remain a non-issue. However, after we emerged from the pandemic, a surge in demand coupled with logistical hurdles led to supply chain disruptions. Conflict between Ukraine and Russia exacerbated the situation and, subsequently, inflation reared its ugly head.

All these factors created an end to the ‘good times’ and ‘easy money’, and in its place we’ve seen tighter financial regulation.

We’re in Tougher Times Now

As borrowing becomes more expensive, we should see a dampening effect on asset prices and corporate profits. Given the sweeping changes in our investment environment, re-evaluating asset allocation within our portfolios has become paramount.

Let me unpack why this has become so important. When interest rates were low, the quest for higher returns led to people taking chances by investing in high-risk companies listed on the stock exchange or engaging in speculative frenzies in cryptocurrencies.

Portfolios were skewed in favour of equities because investments, like bonds and cash, seemed incapable of providing satisfactory returns.

But in this current high inflationary environment, the inverse is true.

In the United States, inflation surpassed 8%, prompting the most aggressive rate hike cycle in history by the Federal Reserve. For the first time in over a decade we’re witnessing significant real yields on US Treasury and other developed market debt. Real yield, which represents the return over and above the projected long-term inflation rate, is a crucial metric.

Fixed income investments like US government debt are looking more attractive and are inching closer to returns produced by stocks listed on the S&P500. Bonds have long been overshadowed by equities but with yields jumping from 0.5% to 4.53% there is a global case for a shift in asset allocation.

What Big Investors are Doing

The significance of this shift lies in the fact that major institutional investors, such as pension funds and endowments, target returns of around 6% and are now viewing fixed income assets as an important part of their portfolio to achieve these returns.

The case is building up for individual investors to consider the same for their portfolios.

There are many advantages to investing in fixed income instruments, particularly in sovereign debt like US Treasury bonds.

Fixed income investments involve a contractual agreement with an issuer, backed by assets, promising a specific yield over a set period.

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US government bonds are considered the safest as they are guaranteed by the US government as long as the investor holds the bond until maturity.

For investors, the appeal of locking in long-term returns has undoubtedly become stronger.

In contrast, equities are invested in with the expectation of a certain return over time. They are riskier though as an asset class, as investors are exposed to volatility.

Investors may still question whether things will stay as they are or if we’ll ever see an extremely low interest rate environment again. We predict this won’t be the case. While rates may see fluctuations as the global economy contracts, we’re unlikely to revert to an environment of near-zero interest rates, cheap credit and low inflation.

As we move forward, lenders will become more discerning, and this could potentially lead to increased depreciation of assets and corporate earnings. Borrowing money will become more challenging, resulting in higher spreads on debt.

In light of these changes, it’s crucial to emphasise that the investment landscape is not the same.

Where to invest, then?

A prudent approach begins with the least risky investments. For instance, lending to the US government at 5% on the dollar is an attractive proposition, especially considering it was yielding a mere 0.25% just 18 months ago.

We believe the current environment signals the need to increase exposure to developed market bonds in individual portfolios.

This normalisation of the global market is anticipated to persist for the foreseeable future.

By entering the fixed income market now, even if yields start to decline, the value of the portfolio through capital appreciation is still likely to increase.

Our aim is not to paint a bleak picture for equities, but we believe diversifying will be critical, as the strategies that worked over the past decade may not yield the same results in the years ahead.

The benefits of a flexible and balanced approach far outweigh those of a rigid, equity-heavy portfolio in this evolving economic landscape.

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