Navigating the new fixed income cycle

By François Collet, Deputy CIO and Portfolio Manager at DNCA Finance (Natixis IM)

There is a lot of noise and expectations around fixed income. So, where do we stand now with this asset class? I strongly believe that the money market is back. And the money market is a very strong competitor for long-term investment in fixed income and for equities today. But, is long-term fixed income back? Its performance could be better than last year, that’s for sure, but would it be better than money markets? I'm not sure at all.

Currently, a lot of people are buying fixed income, which, for me, when it is long-term fixed income, doesn't make a lot of sense: you won’t have higher rates than in the short term; now you can just park your money at 3,25%, or at 3,75% in a few months, at the ECB, while you’re buying long-term bonds below 3% and with a high level of risk. We have to take into account the fact that the volatility of fixed income is much higher than in the past. So here, we have two options: one is to buy an asset that is yielding at 3% with 10% of volatility, and the other which is yielding at 3.5% with 0% of volatility. For me, it's obvious that the money market is a better competitor and that it beats long-term fixed income in terms of sharpe ratio. Furthermore, I think that volatility in fixed income is something more structural than temporary because it is linked to a new period of higher volatility of inflation in a regime of high inflation. In summary, I think we will have a cycle of higher volatility and rates than the previous one, and investors in fixed income should adapt to this new cycle.

We see these changes as something more structural than temporary for fixed income because it’s linked to a new regime of higher inflation and higher volatility for inflation. So, inflation could eventually be back below 2%, but that would be temporary and if it starts to rise again, the central banks will have to start hiking again to curb inflation. That is why I think we’ll see a cycle of higher levels and higher volatility also in terms of interest rates.

But, of course, there are opportunities out there. So, if we continue analyzing the fixed-income world, within the risky parts of the asset class we tend to prefer emerging markets than credit markets. A lot of emerging countries have better fiscal balance, a more orthodox monetary policy and they exhibit a positive current account balance. Fundamentals are for most emerging countries better than developed market countries. But they are yielding at a much higher level. That means that investors are decently paid for taking risks in emerging markets today. Having said that, in terms of emerging markets is important to focus in liquidity. At DNCA we try to stay away from frontier markets, because of the eventual central banks’ balance sheets contractions and we tend to prefer the most liquid emerging markets. To put two clear examples, within the high yield we favour Brazil, where the central bank has room to do a catch-up in interest rates this year, with short-term rates at 13% and inflation below 5%, so they should do that catch-up this year and that would be very positive for the fixed income; and within investment grade countries we see Romania as our preferred country. Meanwhile, for credit markets, the truth is that we are not very sure about credit markets today. But the timing of the next recession complicates the credit market today, so that’s why we prefer to keep a low-risk exposure on the credit market right now.

In conclusion, the fixed income market is interesting right now, but, investors shouldn’t rush to buy long-term debt and should keep trying to protect themselves against inflation. That means variable rates, whether it is with inflation in loans or with floating rate notes, or so on, or just money markets.