The “income” is back in “fixed income”, but what about the “fixed”?

“We favour fixed income segments that offer asymmetry.”

Source: Carmignac, Bloomberg as of September 2023. Yield up and down scenarios correspond to either modified duration or spread duration where most applicable.

Over the past two years, yields across fixed income segments have experienced multiple-fold increases. Core government bond yields are now out of negative territory, those on emerging market bonds have risen by a factor of two (from 4.5% to nearly 9%), and those on European high yield indices have gone from 2.3% to more than 7% – a threefold increase. And yields have now levelled off at these high rates.

The rise in bond yields means that carry¹ is once again a key driver of fixed income performance. This bodes well for the market, since over the long term the main contributor to a bond’s performance is its yield – that is, provided credit incidents are mitigated, which is what active managers are here for. This is especially true now that carry – rather than spread compression² – is the main performance driver. The longer spreads stay where they are, the longer there will be attractive opportunities to seize.

So the question is: if the current situation changes and fixed income markets don’t deliver the “promised” yield (as illustrated by the black bars in the above chart), what can we expect to happen instead and what would be the impact on fixed income markets?

Under our core economic scenario, we expect China's economic recovery to pick up and the US economy to remain resilient, which is likely to support the idea of a soft landing for the global economic cycle over the next six months – an environment that is particularly good for fixed income markets.

The two main risks to our core scenario are either: inflation surprises on the upside, which would push interest rates up as market participants review their expected path for disinflation and monetary-policy; or GDP growth slows sharply, which would lead to lower interest rates, especially given that real interest rates are now particularly restrictive. Both scenarios are illustrated in the above chart by the green and red bars.

It’s interesting to note that in the fixed income space, our simple yet realistic model shows that some segments would deliver positive returns under all three scenarios. Credit markets offering attractive yields, structured credit, and short-term government bonds are particularly appealing and therefore hold a decisive role in our allocation.

So now that the “income” is back in “fixed income”, investors need not worry about whether the environment will be more “fixed” in terms of interest rates.

¹Carry: Carry can be defined as the money an investor will make holding a bond after taking into account funding cost. Carry is a metric that tells investors how time will play in their favour and to what extent (or not!).
²Spread: Bond managers observe yield spreads between different types of bond to compare risk premiums. For example, when spreads narrow between government and corporate bonds, this means that the risk premium between corporate and government bonds is decreasing. As an example, a 10-year Treasury note with a yield of 5% and a 10-year corporate bond with a yield of 7% are said to have a credit spread of 200 basis points.