‘Return to normality’ for multi-asset fixed income allocations

For multi-asset managers, this rapid change of direction with both higher interest rates and inflation looking likely persist mean many are re-evaluating the part fixed income assets can play in their portfolios.

The traditional role for fixed income in multi-asset funds is to act as diversifier and provide protection when equity markets fall. Invesco multi asset fund manager Sebastian Mackay says: “In 2022, fixed income did not protected portfolios as it declined as rapidly as equities.”

In particular, corporate credit experienced a double whammy of higher underlying yields and wider spreads resulting in significant drawdown even in investment-grade bonds, he adds.

Legal & General Investment Manager (LGIM) head of multi-asset funds John Roe adds: “This year is a return to normality with negative correlation re-established between these two asset classes.”

With a return to more normal market conditions, fixed income now has the potential to provide a portfolio with risk, return and resilience.

Tactical timing

While the market correction means bond yields have improved, the ability of this asset class to generate capital returns depends on the economic and interest-rate cycle.

Premier Miton Investors multi-asset fund manager David Jane says: “Now is a particularly good moment to invest in fixed income, because we are at the peak of the economic cycle.”

Royal London Asset Management head of multi-asset Trevor Greetham agrees: “In the US and Europe, it feels like we are not far away from a peak in interest rates.”

While both inflation and interest rates are currently high, forward bond rates are assuming both inflation and interest rates will fall as economic growth contracts. Roe says: “If you buy a bond now you will not receive the current cash rate over the next decade.”

But while the yield potential of fixed income assets might have a limited time horizon, this gives investor a tactical opportunity.

As inflation falls and interest rates are cut, bond prices will rise. Jane adds: “This provides a rare opportunity for fixed income assets to provide some capital gains over the short- to medium-term.”

While some might consider adding to sovereign bond pricing to make the most of the change in the interest-rate cycle to be tactical trading, Greetham argues this exactly what multi-asset managers should do.

It is not just nominal government bonds which currently offer this benefit – so too do index-linkers.

The current high inflation levels now mean the real-yields on UK inflation-linked government bonds have not been this high since 2011, says Roe.

In other words, for the first time in a long time, investors can use this government bonds to generate positive real returns if held to maturity. In addition, when interest rates fall, the prices of these bonds will see their value climb creating an alternative source of return for investors.

Play their part

From a strategic perspective, government bonds and corporate credit have different roles to play in a fixed income portfolio.

Roe says: “Credit is more attractive when the spread relative to a government bond is wide as it offers a good return on the risk-free rate.”

In the current environment where investors are concerned the economy could tip into a much-predicted recession, higher government bond exposure in a multi-asset funds makes sense as a form of diversification.

“At the moment our weighting to government bonds is at a plus one on a duration score which runs from minus three to plus three,” adds Roe.

As the normal negative correlation between equities and bonds has been re-stablished this year, an allocation to government bonds should provide some risk protection, he comments.

An allocation to corporate debt gives multi-asset managers a diversified source of return. Roe says: “While it’s closely correlated to equity performance, in a smaller market turn downs investment-grade bonds will provide protection as defaults are less likely.”

There is not, however, a particularly strong case for owning investment credit right now. Roe explains: “We own less than normal because credit spreads are not that wide despite concerns about recession risks.”

Given the recession risks, it does not make sense to own an asset class which is semi-illiquid, he adds.

Change in duration

For average multi-asset management fund, LGIM has increased its years of duration exposure to government bonds by about 20%.

Multi-asset managers measure their bond exposure not through the proportion of the fund allocated to these assets but the fixed income duration, which measured in years.

Measuring duration in years makes it easy to confuse this with the maturity of the bond – the length of time until the instrument is redeemed.

But duration measures of the sensitivity of a bond – or a fixed income portfolio – to changes in interest rates. “The longer the maturity of the bond being held, and the lower the coupon, the more sensitive it will be to interest rate changes,” says Roe.

If asset managers are concerned interest rates will rise then they will have virtually no duration as bond prices will fall in that scenario.

But as most believe interest rates will fall in coming years as inflation lessens and economic growth slows, they have adds duration to their portfolios.

“Typical duration in our multi-asset funds is now around three to five years whereas it used to be around one year less before the war in Ukraine,” says Roe.

This bond exposure will include both government bonds and corporate debt as the latter has a credit spread as well as the government bond yield, he adds.

LGIM is not the only multi-asset manager to have adds duration; so too has RLAM as well as Invesco.

Greetham says: “We added sizeably to bond duration around Easter, attracted by the higher yields.” RLAM has added between six months to 18 months to its growth and conservative multi-asset funds with no additional duration being adds to its adventurous funds.

The interest-rate cycle is not far from the point when it will make sense to add a tactical asset allocation.

RLAM has not yet made this additional asset allocation because although the market expects a slowdown in growth, it has yet to happen with the economy continuing to chug along, adds Greetham.

Mackay says: “We currently have a duration of in our multi asset portfolios of around three years. Before the war in Ukraine, it was two years.”

Invesco’s multi-asset fixed income allocation is made up of a combination of corporate debt and emerging market local currency sovereign debt. Mackay says: “We hedge the currency so we are only exposed to changes in interest rates.”

Some emerging markets hiked rates much more rapidly when the inflation shock hit than central banks in developed markets.

Mackay says: “It looks like countries, such as Brazil and Mexico, now have inflation in hand which means they are likely to cut rates earlier than in developed markets which increases the value of these assets.”

Corporate credit looks attractive

In addition to these sovereign bond holdings, Invesco also has an allocation to corporate credit through investment grade and high yield bonds in both Europe and the US. Mackay says: “This is quite a significant position for us.”

Invesco has chosen to add risk to their multi asset portfolios through corporate credit rather than adding on equities because it is concerned about the outlook for stocks and shares.

Mackay says: “We think the earnings outlook for equities is quite challenging.” In contrast, the all-in-yield for credit, it looks likely an investor will make a decent positive return on this asset class, he adds.

Janus Henderson EMEA head of portfolio construction Matthew Bullock agrees: “Fixed income now has a return enhancement role to play in multi-asset portfolios.”

Not only are quality fixed income assets providing single digit returns, but these assets can also provide total returns rather than just providing diversification, he adds.

Janus Henderson has concentrated its corporate credit portfolio in investment grade bonds in Europe and the US. Bullock says: “With yields of 5% to 7% in this asset class means we do not need to go down the credit rating to high yield bonds for decent returns.”

Janus is focused on finding those companies which will prove resilient in the face of the expected slowdown in economic growth.

Bullock says: “We’re not ignoring the high yield market as this provides returns of 8% to 9% but if you invest in this market you need to be careful to avoid the more cyclical sectors which will more challenged in a recession.”

By: Charlotte Moore,  freelance journalist