Capital Ideas^TM

A bond’s coupon income, and therefore its carry, is essential to delivering long-term results in fixed income. Along with providing a regular income stream, the coupon also gives a cushion to help smooth out any price volatility.

Not having enough carry can be costly for investors. But equally, if not managed with care, a strategy focused exclusively on income can add unwanted volatility and negate the key roles of a fixed income portfolio, diversification from equities and capital preservation.

Carry exposure should therefore be diversified across multiple sectors and tilted to reflect underlying macroeconomic conditions. A strong focus on security selection can further help ensure carry does not introduce unwanted risk.

Fixed income carry is often equated with credit risk, but in reality, multiple risk factors contribute to a bond’s yield, including curve, duration, FX and liquidity.

Given the current backdrop, a cogent argument can be made to reduce credit risk and, in doing so, scale back carry. The problem is that however persuasive an argument for a particular economic outcome might be, there is no guarantee it will actually happen within the investment timeframe, and waiting has a cost.

This was illustrated in 2023 where, for much of the year, fixed income assets struggled amid elevated inflation, market certainty about the likelihood of recession and a policy of higher for longer by central banks. The backdrop suddenly changed in October, however, when the Fed pivoted. As a consequence, November and December’s results were some of the best for fixed income in history. Bond investors who had chosen to underweight carry and missed these two months would have missed the majority of the year’s gains for the asset class and delivered results significantly behind benchmark.

We think a better approach is to maintain an overweight but diversified allocation to carry with the underlying allocations adjusted to reflect market conditions. In the current environment, this would suggest a more cautious approach with underweights to emerging markets and high yield where valuations have become tight, offset by higher bottom-up driven exposure to investment grade and securitised bonds.

This positioning should enable portfolios to benefit if the recent benign macroeconomic environment persists with the capacity to add more risk if valuations become more attractive. In the event of a risk-off scenario materialising, this relatively defensive positioning should provide some downside protection.