Investing in fixed income appears challenged at a time when UK gilts are yielding 3% (or more) while inflation is current headlining at around 10%. Fixed-interest securities are structurally challenged when inflation and interest rates are rising, as their capital bases and income are just that – fixed. Indeed, investors face a more complicated challenge, not just inflation, but stagflation, which adds recession to the mix. All of which adds uncertainty to the ability of lenders to service and repay their debt, alongside trying to establish the true worth of the overall asset. However, while this environment provides risk, following a sharp re-pricing, it also provides opportunities.
Clear objectives help in the face of extremely volatile markets
The recent surge of inflation, while painful, needs to be put into a longer context when taking investment decisions. We also need to accept that no investment offers the prospect of a 10%-plus return without risk. Therefore, investment objectives should not be focused on a short-term return target, such as whether or not you can beat inflation in the coming year, but rather active management to deliver the best risk-adjusted returns to mitigate the impact of inflation in the longer term and preserve the maximum amount of capital from which to deliver returns in the future.
Preserving capital – what does diversification look like in a fixed income portfolio when inflation is double digits?
Rather than thinking about “fixed income”, it is perhaps better to think about debt as a broader category. We have seen markets develop considerably in recent years in terms of securities that offer income and total return diversification to a multi-asset portfolio.
Asset-backed securities have increased in acceptance – as floating-rate assets they will adjust their yields to reflect rising interest
rates. While they are also unlikely to match prolonged double-digit inflation, they offer a way to hedge rising interest rates. They seem a better play than inflation-linked bonds, where capital values were hit hard in recent selloffs given their sensitivity to interest rates. The linkers market is driven by technical factors a lot of the time and therefore often not a reflection of investors’ view on inflation. The recent volatility we have seen surrounding liability driven investment (LDI) and the impact this has had on the Gilt and Linkers marker is a case in point. So much for it being touted as a “risk free”
investment!
Have we reached the stage yet where credit risk is more important for returns than duration risk?
We have seen a huge repricing in interest rates both in near term but also further into the future – but this does not mean this is fully played out. There is much scope for expectations to change and these shifts present opportunities for the active manager.
However, we are also moving into an environment where an active approach to credit risk is of increasing importance. When (and if) the real fireworks start in credit markets, there will be opportunities. High yield bonds are at an interesting juncture. It is questionable as to whether they are yet offering enough compensation for the undoubtedly higher risk that the current economic environment presents, but there will be winners and losers in the coming years. I think this is one of the most interesting investments to have in your portfolio both for yield, but also capital gains. There are significant opportunities in the Investment Grade market now, such like have not been seen in decades, and while there is an air of caution being sounded given the likely continuation of volatility, you are definitely being paid to take this risk now – but buying the right security is going to be crucial form here.
The investment environment has changed – investment policies will have to adapt – investment principles can still guide us
In broad conclusion, I don’t think there is an obvious “go to” to give investors a real return above inflation when it sits in double digit territory. Any asset offering a double-digit return will undoubtedly have significant capital risks behind it. But we have to remember that, on any but the very shortest investment horizons, inflation is set to be lower from here.
We have been through a prolonged period of low inflation and interest rates and are currently in an adjustment phase back to what have been historically more “normal” conditions. Money is no longer essentially free and market forces, deglobalisation and changing supply chains, without the intervention of central banks, will create more volatility. The best approach now is in keeping calm and looking through the noise to what makes a good risk-adjusted return over the long term. With this in mind, we see fixed income investment playing a key role within a multi-asset portfolio.
