When markets twist and turn, flex your fixed income

Today’s investing environment—characterized by rising inflation risks, elevated geopolitical tensions, and concerns about economic growth—differs markedly from that at the start of the year when the global outlook was more positive and volatility was low. These shifting dynamics are fueling volatility and are unsettling for many investors. Despite this change in backdrop, we believe that the case for an active fixed income allocation as part of a diversified portfolio is stronger than ever, for three key reasons—income, risk management, and flexibility.

1) Attractive income

With meaningfully higher bond yields relative to much of the post‑global financial crisis recovery, fixed income offers investors a compelling source of income. Take the UK 10‑year government bond yield—it fell below 0.1% in 2020 and is now firmly above 4.5%.¹ In the credit sphere, the average yield on offer in U.S. investment grade stood at around 5.14% at the end of March, while global high yield was around 7.3%.²

Such levels are not only attractive from an income generation perspective, but also competitive with other asset classes. The yield on U.S. sub‑investment‑grade bonds, for example, currently exceeds the S&P 500 Index’s earnings yield by over two percentage points.³ This gap highlights the relative attractiveness of fixed income as an income source.

A consistent income stream is especially valuable in today’s more volatile and uncertain markets. It can provide a cushion against price declines and contribute to total returns, helping to support overall portfolio performance.

2) Help balance equity risk

Bonds generally exhibit less volatility than equities, so an allocation can help to balance risk and reduce overall portfolio volatility. Even some of the riskier segments of the bond market, such as high yield, typically have lower volatility than equities.

The return drivers are also different, which can help support portfolio diversification.⁴ Stocks, for example, are generally driven by earnings growth and tend to outperform when economic growth is strong. Bonds are driven by interest rates and typically perform well when growth is weak, although this can depend on inflation dynamics.

In recent years, the diversification benefits of bonds have been called into question, as stocks and bonds have moved in tandem with each other, particularly at times of market stress. However, it’s important to recognize that recent events—such as the Middle East conflict or Russia–Ukraine war in 2022—were inflationary shocks. As a result, bonds came under pressure reflecting the risk of interest rate hikes.

However, there are fixed income tools to help navigate price shocks, such as inflation‑linked bonds. Absolute return strategies, which aim to generate positive returns regardless of market conditions, could also be considered by investors as part of a broader portfolio. These approaches typically have greater flexibility, including the ability to implement short positions, which may help generate a positive return in falling markets.

3) Flexibility

Fixed income features a diverse range of sectors and strategies. This means that, in addition to income generation, bonds could help investors achieve specific investment objectives within their asset allocation construct, including stability, growth, or diversification.

The fragmented nature of the asset class means that what drives one sector of the market is different from what drives another. This provides flexibility for investors to choose sectors that suit their distinct needs. For example:

• If the goal is a defensive portfolio anchor against a growth slowdown, government bonds may be appropriate.
• If the goal is capital appreciation and investors are happy with the higher risk involved, higher‑yielding segments such as sub‑investment grade could be considered.

Navigating today’s energy price shock

In the current market environment of an energy price shock, investors may be seeking to position for rising inflation. One way to do this is to add inflation‑linked bonds, such as U.S. Treasury inflation protected securities (TIPS). In our view, these currently offer attractive value at present. Bank loans may also be appealing in a higher inflation environment, but they require disciplined credit selection as rising inflation could weigh on corporate profit margins. In addition, there may be opportunities in select short‑maturity government bond markets where the pricing of rate increases appears excessive.

The current financial market challenges, including heightened geopolitical and economic uncertainty, are unsettling for many investors. However, with bond yields still elevated, fixed income offers an attractive income stream. This income, combined with generally lower volatility relative to equities, makes a powerful combination. The diversity of the asset class also means that investors can choose a sector or approach to align with their specific objectives. To tap into this, choosing a global manager that prioritizes research is important and should help investors not only uncover potential opportunities, but also manage risks.