A few months into 2022 and it’s already been an interesting year for markets to say the least. Many factors, including persistent inflation, rising interest rates, equity market volatility and global geopolitical instability have come together to paint quite a complicated macroeconomic picture.
Against this colorful landscape, many investors may be looking to add fixed income to their portfolios. Their motivations might include improved funded status of a liability, concern about the equity market and increased yields, among others.
We believe that these investors should consider ideas that:
- Are specific to their goals
- Diversify away from the traditional credit bonds they may already own (i.e., limit issuer concentration risk)
Table 1: Types of fixed income investments and their potential benefits
Liquidity solutions
Who – Investors drawing on assets for near-term spending needs where inflows and outflows are uncertain
What – There are customizable solutions available to meet investors’ liquidity needs effectively, while still managing long-term return goals. Previous years’ cash flows can help determine an investor’s most immediate liquidity needs. It’s then possible to create a tranche of more liquid assets that aim to meet those needs alongside another tranche or tranches that account for other goals that don’t necessarily require as much liquidity or stability. So, for example, an investor’s assets could be divided into three tiers, one that requires greatest liquidity to fund regular expenses, another that’s slightly higher yielding and slightly less liquid, in case the need for extra cash should arise and a third comprised of more aggressive, more illiquid assets that could help generate yield while introducing more volatility.
Why – A customized liquidity solution can be created to seek to avoid excess cash in low yielding liquid strategies, maximize assets in the highest-yielding strategies and successfully meet liquidity needs
Fund finance
Who – Investors with minimal liquidity needs trying to maximize yield with little volatility
What – Private credit with gross target IRR of reference rate1 + 165-200bps and minimum two-year term, as well as a low default rate and correlation to public markets
Why – Fund finance aims to capture private markets’ illiquidity premium without assuming undue credit risk. Investors may be able to achieve a higher return than cash — with similar volatility — by sacrificing liquidity.
Municipal (muni) bonds
Who – Investors seeking diversification from traditional credit and/or Treasuries
What – High-quality bonds issued by municipalities with yields closer to corporate bonds and correlations to Treasuries and Credit of 0.8 and 0.7, respectively. Munis have materially fewer defaults and higher average recoveries than corporates. There are also opportunities within the muni bond space to incorporate environmental, social and governance (ESG) considerations. ESG analysis can serve as a valuable risk-management tool because investments that present ESG risks are more susceptible to credit downgrades.
Why – Muni bonds are a means of adding fixed income to a portfolio while seeking to diversify away from current credit and Treasury holdings. They’re also defensive and are likely to outperform corporates if we experience a widening of spreads.
Utilities/infrastructure
Who – Investors concerned about spread widenings and/or inflation
What – Fixed income investments that target the utility or infrastructure sector of the market. Utilities have historically experienced 75% of movement in corporate spreads, resulting in 5.5% outperformance during the five most recent spread-widening periods.
Chart 1: Total return during periods of widening spreads
Why – With corporate option-adjusted spreads (OAS) relatively tight, fixed income strategies that historically participate less in spread widenings have potential relative to traditional fixed income. Utilities/infrastructure may also benefit in the near term from government infrastructure spending and increases in revenue that are tied to inflation.
Crossover bonds
Who – Investors seeking greater return potential than traditional bonds
What – Securities that are close to the dividing line between investment grade and high yield. When a bond gets downgraded, prices may temporarily drop below their fundamental values, but over time return to equilibrium levels as the selling imbalance abates.
Why – A “sell-now-ask-questions-later” reaction to downgrades can create market inefficiencies and opportunities. Active credit selection can identify those bonds downgraded that are potentially able to regain their prior rating.
Long-duration credit
Who – Investors targeting a specific duration, likely to hedge a liability
What – High-quality credit bonds that are highly sensitive to movements in interest rate (i.e., 10-15 years of duration). In most yield-curve environments, long-duration bonds offer higher yields than traditional credit bonds.
Why – In addition to offering a potentially higher yield, long-duration credit may also help investors who are targeting a specific duration for their overall assets. This is a common strategy for those who may benefit from matching the movement of their assets to the movement of liability when interest rates change. Asset/liability analysis can be performed to quantify the strategic benefits of hedging liability and the specific duration to target.
Unconstrained global credit
Who – Investors seeking both higher return and diversification from traditional credit
What – Actively managed global credit targeting a 3-6% return with a low-duration bias. Unconstrained global credit can identify mispriced companies and structures that offer a compelling total return.
Why – Expanding the universe of potential securities can bring strong diversification to a fixed income portfolio and create opportunities for active management to add value
Emerging markets (EM) debt
Who – Investors seeking fixed income with even greater return potential and diversification
What – Local currency sovereign, hard currency sovereign, and corporate debt issued across more than 80 non-developed markets
Why – While we expect a moderation in global growth from 2021, the trajectory remains above trend despite the tighter monetary conditions and EM yields are attractive at current levels. On monetary policy, some EM central banks may over-tighten, providing scope for easing toward the end of the year. The Omicron Covid-19 variant continues to lead to fewer severe outcomes than earlier virus strains, allowing further economic re-openings and recovery in international tourism.
Conclusion
There are many reasons for investors to consider fixed income as part of their portfolios. And there are many different types of investors and multiple fixed-income strategies for them to choose from. But we believe that for any investor to try to make their best fixed-income decision, they need to account for their specific investment needs.
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- Reference rate refers to a short-term bank lending rate that may incorporate Euribor, an overnight interbank rate comprised of average interest rates from a panel of large European banks, and SONIA, the Sterling Overnight Index Average, the effective overnight interest rate paid for by banks for unsecured transactions in the British sterling market.