- Fixed Income Portfolio Manager
Finland, Institutional
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Key points
- Today’s more volatile backdrop is a timely reminder that investors cannot predict markets. However, volatility can be a boost to fixed income investors, provided allocations are flexible enough to benefit.
- That said, flexibility should be paired with discipline so as to avoid unnecessary risk.
- Investors should also be mindful that focusing too much on yield could mean they risk overpaying for income and underestimating the impact of price volatility on returns.
Today’s fundamentally different economic era — defined by structurally higher inflation, greater volatility and more frequent market cycles — can present compelling opportunities for active fixed income investors. I believe this to be the case not only in spite of greater uncertainty, but in some instances, because of it. This is because, in my view, uncertainty can create opportunity for fixed income investors, provided they can achieve the right balance between flexibility and discipline.
How bond investors can harness uncertainty
We tend to view fixed income markets as a constantly evolving equation. Simply put, this means there's a good result (outcome A) and a bad result (outcome B). But I believe trying to predict the right future outcome and position your portfolio accordingly is futile, especially given the inherent unpredictability of the new economic era.
Instead, I find more value in identifying a crowded trade — where the probability of outcome A is perceived to be much higher than the probability of outcome B — and analysing why outcome B may be more likely than market consensus and pricing imply.
When you apply this way of thinking, uncertainty can create opportunities for bond investors to capitalise on mispricing. The current market environment — featuring greater performance dispersion across regions, sectors and issuers, as well as higher inflation and greater cyclicality — presents us with many such opportunities.
Positioning amid uncertainty
How might this approach work in practice? Two examples come to mind. The first relates to the consumer finance sector in 2023. Going into 2023, the market was concerned about outcome A - the impact of interest rate hikes by the US Federal Reserve (Fed), believing that consumer finance companies would be particularly at risk if recession fears materialised. While we couldn’t dismiss the possibility of a recession, we hypothesised about the probability of outcome B — the US consumer was in a far healthier state than the market realised, interest-rate hikes were having less of an impact on consumers than had been feared, and small businesses were not as dependent on regional banks as the market seemed to think they were. Working closely with sector-specific experts and diligently analysing alternative data meant we were able to position portfolios to capitalise on this mispricing and uncertainty.
A live example presents itself to us right now. I think uncertainty around the impact of the Trump administration’s policy mix can also be viewed through this lens.
If outcome A is that the Trump administration’s policies have a positive impact on US growth and lengthen of the economic/credit cycles and outcome B sees the policies trigger a negative growth shock and tighter financial conditions in the US, I think the latter could be more likely than the market expects.
Trump’s re-election seems to be accelerating underlying trends around weaker labour supply and a deteriorating fiscal backdrop. While tariffs may turn out to be a negotiating tool, I see them as the only significant “source of funds” in his economic plan. In other words, the administration may need tariffs to fund tax-cut extensions and further stimulus. What this misses, of course, is how disruptive this posturing is for global trade.
Tighter immigration policies could also be growth negative. Immigration has not only been a positive catalyst for labour supply growth but also a stimulant for demand. With fewer people seeking housing, food, goods and services, will prices adjust downward? The effects could be especially acute in the housing sector, as the US has been aiming to close a structural housing-supply deficit.
Positioning for uncertainty
So how can bond investors leverage uncertainty to their advantage? We think the following five considerations may help.
First, bond allocations need to be flexible enough to take advantage of dislocations as they occur. An unconstrained approach has a greater ability to capitalise on opportunities than a benchmark-orientated approach does.
Second, we believe flexibility must be paired with discipline. An unconstrained approach can capitalise on opportunities, but it can also leave investors exposed to unnecessary risk. Employing a resilient and consistent framework to continually assess the upside and downside risks of every decision and possible price outcome can help investors seek to achieve an “all-weather” total return experience.
Third, focus not only on income but on total returns. Investors who focus too much on yield risk overpaying for income and underestimating the impact of price volatility on returns. Comparing a bond's cumulative return from income versus its rolling price change over time serves as a good illustration of the importance of paying attention to total returns (Figure 1). An income-based investor who does not pay attention to total returns could see periods where they face a drawdown of close to 20% on some of the bonds in their portfolio. On the other hand, an investor who takes more of a total return approach and who is able to be flexible can potentially seek to monetise uncertainty by responding to changes in market conditions, ultimately aiming to avoid most of the initial drawdown and instead participate in a subsequent rally.
Figure 1
Fourth, consider multiple perspectives. As fixed income investors, we naturally scrutinise central bank movements, inflation levels and macroeconomic indicators. But bond investors have much to gain from perspectives that might not immediately come to mind, such as looking at issuers with an equity investor’s lens or assessing the potential impact of geopolitical shifts.
Fifth, retain enough liquidity without waiting for negative market events to occur so that it’s possible to take advantage of opportunities as they arise. Maintaining a high level of “dry powder” while spreads are tight can offer investors the potential to buy on dips when spreads are relatively more attractive.
Bright spots exist, if you can capture them
Today’s more volatile backdrop is a timely reminder that investors cannot predict the market environment. However, volatility can be a boost rather than a hindrance to performance if one is willing to think critically about the ever-evolving probabilities in fixed income markets and dynamically move their portfolio to perform well across a market cycle.
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