Alternative Reality - How The Fixed Income Landscape Has Shifted

Financial Advisory

27 April 2023

active managementBondscomplianceFinancial AdvisoryFixed IncomeMeeting of MindsRegulation

Expert: Matthew Russell, M&G Investments Facilitator: Sam Shaw


  1. Now is a good time for short-dated credit. 2022 saw a lot of people lose a lot of money, which refocused their minds to the fixed income space, given bonds are traditionally seen as a ‘safer haven’ – especially at the lower duration end
  2. Good investors/fund managers take risk when they’re being paid (ideally overpaid) for taking risk. Right now, is presenting a ripe opportunity to get higher returns for less risk on less interest rates – i.e., the short end of the yield curve is paying a premium
  3. When rates rise, short-dated credit offers better protection against capital losses than more traditional credit funds. E.g., in a short-dated, 1–3-year corporate bond index last year, at the worst point, the maximum drawdown (total returns) was about 10%. In more traditional corporate bonds – representing the market as a whole - it was close to 30%
  4. If we're going into a harder recession, that's bad for credit spreads, but government bond yields tend to rally, so it would likely overcompensate investors (even in a very deep recession), because of the capital gains generated from interest rate cuts
  5. Conversely, if the economy strengthens, and inflation is harder to get rid of, leading to more rate hikes, it’s a good scenario for corporates, because the economy will be doing well. So, you'll see credit spreads tighter, and the two will offset each other.

Discussion points:

Observation from the table: Most strategic bond fund managers have moved more short duration in recent months.

This is not just a UK story; we are seeing similar for US and European credit. UK is quite an extreme example, because it's a longer duration asset class than in Europe or the US.

For longer-dated (c.6.5yrs) All Stock dollar bonds and shorter-dated US Investment Grade (c.2yrs) – the yield is the same. This is the same story in Europe. Yet the maximum drawdowns in the short-dated credit was around 6% in the longer leg to credit it was 20% (16% for Europe)

In short, in UK, US and Germany, the front ends are getting paid quite a decent premium, versus the longer-dated bonds.

Why active management is crucial now, especially looking at investment grade:
Universe: In times of volatility, a deep, diverse universe provides plenty of dispersion between sectors, industries and individual bonds which presents relative value opportunities. In this environment, active managers should be outperforming the index.

Firms with large credit teams can interrogate those credit ideas properly and spot the opportunities early.

Compelling yields: IG’s all-in yield is a lot higher now – the highest they have been in over 10 years – which makes it more interesting vs high-quality equity. Where is the benefit of going into equities, when you when you've got a contractual agreement in a bond which offers more certainty over your cash flows?

Lower default rate: If there will be a recession at some point, it's not going to be a financial crisis; it's not 2008. So, in general there's going to be lower default rates.

Market is pricing in c.13% default rate for BBB bonds, while history says this is unlikely – the worst five-year period ever, was c.5% defaulting (dotcom bubble), and the average is 2%.

In-built hedge: Now we’re back at more ‘normal’ yields – back to 5-6% rather than 1-2%, corporate bonds have got an in-built hedge in to the economy, to the way that interest rates and credit risk move.

Why invest in bonds when you can get near 5% in cash savings?
If the best saving rate available at the moment is Apple and Goldman Sachs, which is offering just over 4%, a short-dated credit fund is “the first step out beyond that”.

The current yield before fees is about 5.5%, so we are around 1% more than the best bank account – it’s not a risky fund; it’s the most defensive fund M&G offers.

One delegate said his conservative clients performed the worst last year because of their exposure to fixed income. Begs the question, why take market risk now when you can 4.25% or 4.5% in a one-year fixed cash account? No market risk and no real banking risk either, because the government will step in.

Three ways to move ‘off benchmark’:
Active global credit: Being currency-agnostic, if a company issues dollar, sterling and euro bonds, all with the same maturity, and the same credit risk, but one is offering a wider spread it's providing a higher yield after you adjust for the FX hedge. Having that flexibility is important as if the relative value switches back, we can follow suit. You should buy the one that offers the highest yield after taking into account the cost of hedging the FX risk.

Benefits from rising rates: M&G likes floating rate notes – bonds where the coupon adjusts up or down with the prevailing interest rates. As many retail investors seem to seek capital preservation, because of their floating rate nature, as yields go up, the coupon adjusts up. So it helps to maintain the, the actual value of the bonds and therefore the portfolio.

ABS research premium: Also, a floating rate asset class, these offer a relative value call. E.g. some AAA -rated ABS offers a similar risk premium to BBB corporates of a similar maturity. Also, M&G has a large team of ABS specialists and manages >£20 billion in ABS.

Key takeaways:

Future points to consider/next steps and issues with compliance, risk-models and regulation predicted under this paradigm shift:

  • Is the story different for the group of clients for whom the shocks look quite tactically strong, than for the clients who have already lost money on an average duration portfolio? “That's the kind of dialogue we're having - do I hold on to wait for those yields to come down? For my capital value to appreciate again?”
  • Several advisers expressed concern over how to run their CIPs, where to allocate in light of the losses from the bond exposures.
  • “How do we risk-rate clients going forward?” After a 40-year bond bull market, everyone's forgotten about the risk of fixed income because bonds & interest rates have only been moving in one direction. Yet clients in their 80s are “packed with gilts, getting hammered and none of them will live long enough to recover those losses”. How do we risk-rate clients in that demographic or age group now?”
  • “Most of our clients are looking for all-weather portfolios. It was said this morning that the average client age is 56 or above, these are people approaching retirement or in retirement, they're not necessarily filling the pipeline with new money. So all the money they have is all the money they're ever going to have. So it's our job to preserve that, pass on to the kids, help them get their income from it, etc. it's hard not to take it personally as an adviser when you see your clients’ outcomes being bad. But it's a bad place to be.”
  • “Early last year, we all saw signs of inflation coming and wanted to move conservative clients up the risk spectrum, compliance wouldn’t let us. The definition of risk is aversion to capital loss. Some of the off-the-shelf portfolios we are in don’t seem to know this, because they’ve got 70% in fixed income, and there's nothing I can do about it. And the FCA has said nothing about any of this. How do you respond in this new paradigm?”
  • “Those risk profile reports are all built on volatility that the corporate bonds will then go to the higher end of the risk spectrum, the lower risk assets will go to the young bucks who want lots of risk. It feels like a change of in paradigm.”