With bond yields returning to pre-global financial crisis levels and debt markets facing new winds of change, how can portfolio managers best deliver a positive outcome for fixed income investors? Here, Insight Investment head of global credit, Adam Whiteley, ponders shifting market fortunes and the wider outlook ahead.

Bond markets are on the move, as fixed income investors continue to adapt to what has widely been described as a ‘regime change’ for the wider investment sector. Post global financial crisis (GFC) measures such as quantitative easing (QE) - and the sustained near zero interest rates that accompanied them - have given way to higher rates and the return of inflation, in turn boosting fixed income opportunity.

Recent months have seen central banks such as the Bank of England (BoE) and US Federal Reserve battle to contain stubbornly high inflationary spikes, which have helped fuel a wider cost of living crisis. Now, with some signs of inflation coming under control, fixed income investors are weighing their options in markets which are seeing some of the highest yields since the GFC first broke.

Inflationary pressures

Commenting on the UK inflationary picture and the impacts of recent BoE intervention in the market, Insight Investment’s Adam Whiteley says: “Although we believe the BoE is nearing the peak in its rate hiking cycle, inflation remains stubbornly above central bank targets, while the labour market is also tight.

“The positive environment for risk markets looks likely to last longer into 2024 than previously expected, but it could still prove to be more transitory in nature if core inflation remains sticky and monetary policy remains tighter for longer. Against this backdrop, we believe this shifting environment requires a slightly different, more strategic, way of thinking and a more nuanced investment approach that can respond to these different conditions.”

Assessing the wider credit outlook for the Responsible Horizons Strategic Bond strategy he leads, Whiteley adds: “The demand picture for investment grade credit appears strong for both institutional and retail investors attracted by yields that now exceed the dividend yields of their headline equity counterparts.

“Any periods of spread weakness could present investors with opportunities to add exposure in this area. However, we remain cognizant that there remains significant uncertainty around the trajectory for inflation, central bank reaction functions and market volatility.”

Beyond immediate market movements, Whiteley points to a growing trend among fixed income investors to invest responsibly via vehicles such as impact bonds, as they consider their strategic approach to portfolio management in shifting markets.

“Impact bond growth has been rapid in recent years with many public and corporate issuers coming to market and much of this issuance potentially offering social and environmental benefits. Indeed, global green bonds have been one of the fixed income sectors to show some of the most market growth most over the past decade.

“Another approach is for investors to take a proactive role in supporting companies seeking to transition areas of their business to help improve their sustainable characteristics by investing in their debt and actively engaging with them,” he adds.

Default outlook

While investing responsibly can bring its own benefits, fixed income investors must always keep a sharp eye on returns and the likelihood of credit default. For now, Whiteley sees a broadly benign default outlook, though with pockets of volatility still periodically buffeting the market he stresses investors should remain vigilant.

“In our view, default rates are extremely low in an historical context though we do anticipate that changes in the interest rate cycle and moves towards a more inflationary environment could lead to an upward turn in defaults. That said, we suspect the pace and peak of this change will be slower and lower than some analysts are predicting.

“On a sectoral basis we do, however, remain cautious on high yield within investment grade mandates. We believe spreads could decompress if high yield relative valuations become stretched and/or if the tepid growth outlook causes an uptick in high yield defaults. Historically, defaults tend to be more of an issue for high yield bond investors and less so for investment grade credit which is an asset class we prefer to invest in,” he concludes.

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