How to invest in fixed income in the current environment

The expansion of central bank balance sheets since the financial crisis has driven yields down across government and corporate bond markets. Meanwhile, the global economy is still characterised by anaemic growth in the developed world.

Policymakers are likely to turn to a combination of fiscal and monetary policy measures to boost growth, but the future is unpredictable. The global economy is vulnerable to further crises, and the potential for further market volatility remains.

With regard to corporate bond markets, although management teams have generally adopted prudent practices since the early part of the millennium, over the past few years a low-growth environment has encouraged them to raise debt to deliver growth to shareholders via equity buybacks, higher dividends, and mergers and acquisitions.

This has caused a rise in leverage that has contributed to a general fall in credit quality. Since 2009, the proportion of AAA-rated issues within the global investment grade corporate bond market has fallen from more than 7 per cent to just over 1 per cent.

With corporate earnings generally on the decline, there is a danger that companies may increasingly have to dip into their cash reserves to service debt, sharply increasing default risks. Historically, negative earnings growth has broadly correlated with default rates.

It is true that with a large proportion of government debt in negative-yielding territory, the debt burden for corporates remains relatively manageable.

However, a sharp uptick in yields would not be without precedent even without a central bank catalyst – witness for example the sudden surge in bond yields during the second quarter of 2015. Furthermore, as credit spreads tend to be pro-cyclical, investors could be exposed to renewed market weakness, leading to a sustained widening in credit spreads.

Fixed income investing in light of uncertainty and volatility

In an environment of central bank intervention and potentially rising defaults, more volatility is highly likely.

In the event that monetary policy fails to support markets, investors could be exposed to downside risks if defaults rise and prices fall. To combat this, investors can position to take advantage of bouts of volatility.

There is a danger that companies may increasingly have to dip into their cash reserves to service debt, sharply increasing default risks

Fixed income investors should consider either absolute return or buy-and-maintain approaches to fixed income. With regard to absolute return, an unconstrained portfolio that can allocate long or short across the full tradable fixed income opportunity set – including government bonds, investment grade credit, high yield, loans, asset-backed securities, emerging market debt and currencies – should have the flexibility to add value even in difficult conditions.

Buy-and-maintain portfolios typically focus on purchasing robust and attractive debt for the long term. By only selecting long-term high-conviction issues, a strategy can focus on avoiding forced selling following downgrades. This is of crucial importance if fixed income markets face a vicious cycle of defaults.

When allocating risk, it is important to avoid exposure to assets of less robust credit quality purely as a means of chasing yield. Bottom-up diligence and stock selection will be key for the foreseeable future.

Given lower liquidity, adopting a long-term time horizon with every asset an investor purchases is also appropriate. The old adage of ensuring returns adequately compensate you for the risks has seldom been more crucial.

In light of this, long-term investors such as pension funds should consider whether secured multi-asset credit strategies may be suitable. As they exclusively invest in secured investments, such as asset-backed securities and collateralised loan obligations, they can offer higher credit spreads than equivalent-rated corporate bonds, reflecting a premium for complexity without exposure to additional credit risk.

Alex Veroude is head of credit markets at Insight Investment