I struggle to get excited about equity investments in the current market environment. For every “pro” I can name a “con” as we walk the tightrope of monetary-policy tightening alongside slowing growth and inflation. Soft landings. No landing. Hard landings. They all have their arguments and many of them valid. One area where I can, however, see the risk/reward trade-off as skewed in your favour is in fixed income.
Not often do we talk of equity-like returns within fixed-income markets, especially over the last decade of low yields induced by quantitative easing. But as we survey the fixed-income landscape we see high single-digit and low double-digit returns on offer in many segments of the market.
Last year was a wake-up call to many multi-asset managers that duration cannot be ignored, as previously “safe” investments such as government bonds sold off by 20%-30%. The duration trade was over and those who had ignored it were licking their wounds.
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Within our portfolios we have been extending duration again recently, having been underweight throughout the past 12-18 months, and we are approaching strategic asset allocation levels again.
We believe the defensive characteristics of fixed-income are likely to have returned – with a substantial resetting of yields over the last year.
A yield differential in our favour
Our preference had been for US Treasuries thanks to the higher yields initially on the table and the late but subsequently decisive rate-hiking trajectory that the Federal Reserve took us on. More recently we have been pairing this with UK gilts as the yield differential flipped in their favour, and you could pick up an incremental 40-50 basis points by moving into Britain.
Within corporate bonds, short-dated sterling corporate bonds currently offer the best yield-to-worst and spread over their government counterparts as we look across the globe, though at the expense of some liquidity and the idiosyncratic risks the UK seems to be facing compared with its global developed market counterparts.
Between the US and Europe the trade-off is a little more balanced, with higher sovereign yields and a tighter spread in the US, or lower sovereign yields and a marginally higher spread in the eurozone. We like both on an all-in-yield basis, particularly given the current record tight equity-risk premia, but would seek the relative safety of good-quality investment grade in the belly of the curve (between three and five years) at present. There are plenty of active managers out there taking on this trade, but equally passive exchange-traded funds (ETFs) or unit trusts can deliver you low-cost exposure within the investment-grade allocation. We use vehicles such as the Vanguard Global Credit Bond Fund (actively managed), or the iShares GBP Corporate Bond 0-5 Ucits ETF (LSE: IS15).
For those wanting to offset the risk in their equity portfolio, we would advocate positions in actively managed high-yield bonds. For a time last year we would have considered passive high-yield too, but spreads have tightened since then and we would stick to active managers at this stage in the cycle. The Man GLG High Yield Opportunities fund is our favourite here for the broad toolbox they use. Going into a potential recession these investments could be volatile, but on a risk-adjusted basis should deliver returns in excess of equities from current levels.
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