The era of unconventional monetary policy, with central banks deliberately keeping interest rates below the rate of inflation, in order to “save” markets, has pushed bond yields to exceptionally low levels. The result has been much less pronounced credit and economic cycles and higher volatility.
In fact, the unprecedented monetary and fiscal stimulus following the Great Global Financial Crisis and Covid-19 pandemic has distorted global fixed income markets and altered investors’ attitude towards risk. Another side effect is the increased correlation of traditional credit markets with equities, which reduces the margin for error. Interestingly, more recently, bond volatility has skyrocketed even with volatility relatively stable in equities, an anomalous condition for which few fixed income investors were prepared.
But this era is coming to an end amid rising global inflation. In addition, more and more passive products are available, and, as more investors enter and exit the market simultaneously, volatility increases. Add to this is a huge deterioration in credit quality of issuing companies. Another significant risk is a failure in monetary or fiscal policy. In addition, investors worry the end of decades of desinflation.
Thus, volatility, which has increased considerably in recent weeks, is not going away. This suggests that are no longer the safe haven they were, with significant risks for those who hold longer-term debt, including pension funds.
So the return characteristics of fixed income assets will not be as benign as in the past four decades. But corporate debt must be an important part of any diversified portfolio, as can provide attractive opportunities throughout the cycle. Investors therefore need to be aware of the serious problems that are accumulating and rethink the role of fixed income in their portfolios. In this regard, Charles Ellis, in his 1998 book, Winning the Loser’s Game, observed that successful athletes tend to be defeated by those with superior abilities, but fans are defeated by their bad game, unforced errors. By extension, investors should avoid mistakes, such as unnecessarily chasing yields to maturity.
Thus, it is possible to reduce risk when valuations are tight and take advantage of opportunities to add it when other investors fear. This value-focused mindset provides the strongest foundation on which to navigate volatility cycles. It has been the case in the pandemic. By March 2020 many investors with high-yield debt suffered significant losses in the worst of the crisis, unlike those who had taken steps to take advantage of the value offered by good quality credit. The requirement is to be agile enough to acquire good quality assets with attractive profitability, not correlated with other assets.
Today, interestingly, investment-grade credit seems particularly risky. This is because asset allocation decisions in this part of the market have very little room for error, as there is a high proportion of investment-grade credit on central banks’ balance sheets, which can affect their liquidity. Although there may be entry points in national champion issuers and sector leaders, certain “rising stars”, i.e. companies with high-yield debt that are deleveraging, whose financial prospects have improved, offer much more attractive prospects in relation to risk.
In any case, it is important to remain flexible, with exposure to less inflation-sensitive assets, such as variable-rate debt and certain convertible bonds.