Generational fixed income opportunity

Current rates, the result of painful monetary tightening, are at historically attractive levels. (Photo: 123RF)

Looking back, the last decade has presented significant challenges for fixed income. Structural trade-offs were introduced into portfolios, such as sacrificing liquidity or accepting different types of risk in order to obtain barely acceptable nominal interest rates. Today, however, we believe that this dark period is finally over.

Global fixed income rates have returned to historically attractive levels. Indeed, after a period of increased reliance on non-traditional sources of current yield, many investors are exploring the overlooked growth potential and diversification benefits of government debt markets.

Despite the improving environment for fixed income, uncertainty and volatility remain high. Global central banks are at different stages of their monetary policy cycles, and as growth varies across regions and sectors, we have seen several disruptions in the markets.

These different conditions generally lead to greater dispersion of returns within and between markets. This is not necessarily a bad thing, especially for active managers who can spot relative value opportunities and provide a performance advantage in this challenging market environment. Relative value, geographic diversification, asset allocation and sector allocation, and last but not least, the selection of debt securities, which is based on a careful research process, are the levers that the active manager usually used when trying to generate alpha. Overall, while we are bullish on debt securities, selectivity will be key.

Consequences of rebalancing rates

Interest rate cycles move at different rates depending on the local economy, and the dispersion of spreads creates more relative opportunities for appreciation. Moreover, even if interest rates were to rise, today’s high rates provide valuable protection against falling prices. In other words, turning points are attractive. The tipping point is the increase in interest rates necessary to offset the annual interest income and bring the total return to 0%.

The recent positive correlation between bonds and stocks has cast doubt on portfolio diversification, but we believe this is a temporary phenomenon. The correlation between bonds and stocks is expected to decrease as market conditions normalize.

Current rates, a result of the painful tightening of monetary policy, are at historically attractive levels, meaning that there is no longer a need to discount risk and liquidity to achieve higher rates. As a result, investors looking to reduce risk should be sure that a bond’s yield represents a significant portion of its return.

Current entry rates indicate significant return potential. Although strong cash yields last year encouraged investors to hold cash, our research showed long-term bonds posted strong returns as central banks completed their tightening cycle.

The case of global bonds

Currently, global interest rate developments are less synchronized than they have been in recent times, providing investors with an opportunity to allocate capital to markets further down in their interest rates. When we look at global markets, we see that yield curves have different shapes. Fixed income investors may have an opportunity to take advantage of these generational valuation levels.

On the growth side, fundamentals such as credit quality also vary across global markets, with some having greater potential given their economic conditions. Canadian investors can benefit from attractive rates compared to local rates depending on the sector and possible rate cuts over the business cycle in other markets.

The Bloomberg Global Aggregate Index is commonly used to understand the global fixed income market. This index is limited to investment grade issues and is less volatile (see chart) than many expect, especially compared to the Canadian bond market.

In addition, the characteristics of the Bloomberg Global Aggregate Index also differ from those of the Canadian world in other respects, which could provide diversification benefits, given the limited overlap of Canadian bond markets (3%) and differentiated quality and sector distribution.

We believe the current global fixed income environment offers a significant opportunity to increase income and improve downside risk management. Given the attractive rates and low volatility, we believe the risk-reward potential of the global bond position is very attractive to Canadian investors. If economies recover and policy rates decline, we believe global fixed income should contribute to performance and play a role in portfolio construction.

Opportunities for pension funds

Defined benefit (DB) plans can benefit from weighting in global bonds. Better funding levels and shorter liability maturities may allow US pension plans to cover a greater proportion of liabilities through physical bonds, reducing reliance on derivatives. Global bonds offer these plans an opportunity to diversify their exposure to fixed income without disrupting the duration profile of typical liability investment strategies. While the dynamics of Canadian DB plans differ in some ways from their US counterparts, we believe global bonds could be an area to explore for DB plans on this side of the border.

In a world where capital must be allocated responsibly, the benefit of exposure to global fixed income is obvious for long-term investors. Attractive yields, favorable credit conditions and planned central bank easing measures highlight the need for robust, integrated global research to identify attractive regions and sectors and uncover opportunities for relative value during this generational shift in the investment world.

Text by Frédéric Belhumour published in the April 2024 edition of Avantages magazine.

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