Capital Ideas^TM

Introduction

Investing in fixed income has lost its appeal for many investors in a world where inflation is overshadowing bond markets, central banks are hiking interest rates and returns look relatively uninspiring. With that in mind, now’s a perfect time to revisit the question: why invest in fixed income?

In those moments of uncertainty and heightened volatility, it is important to stop and reflect on the basic role of fixed income and its overall impact on portfolio allocation. While the primary objective of investing in equity is capital growth, fixed income helps serve four key roles in a portfolio: capital preservation, income generation, inflation protection and diversification away from equities. As a fixed income investor, it is crucial to focus on the return of capital rather than the return on capital.

Although the opportunities for returns in a low yielding environment are harder to find, it is important to remember that the bond market is by far the largest securities market in the world. The market has grown tremendously both in terms of size and number of issuers, creating many investment opportunities.

As mentioned above, bonds serve four key roles:

1. Capital preservation

2. Diversification from equity

3. Income

4. Inflation protection

The different fixed income asset classes such as developed and emerging market government bonds, investment grade and high yield corporate bonds and inflation linked bonds, can provide various outcomes for investors. For example, relative to the other asset classes, global Treasury bonds could offer an effective hedge against equity exposure in portfolios, given their generally steeper yield curves and longer duration position. On the other hand, high yield and emerging market bonds are better suited to fulfilling the role of income generation, given the higher nominal yield present in these markets.

1. High quality government bonds offer tail risk hedging and potential downside protection

Investors have typically used fixed income to offer protection during equity bear markets. However, the correlation between equity and fixed income markets has increased recently, which led to many questioning the role of fixed income in a portfolio. While we acknowledge that there have been periods when the correlation between the two asset classes was positive, if we take a long-term perspective then more often than not, equities and high quality government bonds have shown a negative correlation. Therefore, increasing the fixed income allocation in a portfolio could help mitigate downside risk.

Tail events are generally difficult to predict, so protection from tail events can be a valuable component of a diverse portfolio. In periods of market stress with sharp equity market correction, high quality government bonds, particularly the longer dated bonds, have continued to provide real downside protection, even with very low or negative yields such as those seen in Europe.

Consider the current market environment where inflation is high, and many central banks are embarking on interest rate hiking campaigns. High quality government bonds tend to underperform alongside expected rate hikes as yields tend to increase. However, yields on short-term bonds tend to increase the most, while at the longer end of the curve (10 years and out), the upward movement in yields is far more muted. This is because the purpose of rate hikes is to curb excess demand and suppress inflation, which in turn dampens inflation expectations. Read our full paper on fixed income and rising rates here: Fixed income and rising rates

Overall, although the market tries to find alternatives to high quality government bonds as a form of tail risk hedging, we think they remain the most liquid, simplest and effective instrument relative to other opportunities such as options-based or long-short equity strategies.

 

Risk factors you should consider before investing:

• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
• Depending on the strategy, risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.