Taking Interest - The case for reviewing bond allocations in a more polarised world

23 March 2023

BondsFixed IncomeGatekeepersInterestMeeting of MindsPortfoliosvalue

Facilitator: Paul Kearney. Moderator: Mark Dowding


  1. Investors should re-consider a passive approach to fixed income
  2. Inflation will not revert to the levels seen in the last 10 years
  3. The era of there being no alternative (‘TINA’) to equity allocations has come to an end. Some Family Offices have not bought a bond for 10 years
  4. Value is back in fixed income. A year ago there was “no income left to fix” with ‘high yield debt yielding 3%
  5. With value returning to FI, the current environment leads to the need for insight and realtime views

Discussion Points:

As yields fell into negative territory why own fixed income assets, given low yield and a high correlation to risk assets. However, since 2020, fiscal and monetary support has been driving up asset prices. 

The purpose of fixed income is to provide ballast in portfolios. As the “zero yield asset class” it wasn’t doing its thing. 

So why did investors bother holding FI. In short, they had too - mostly driven by regulatory requirements. Although the lower volatility of the asset class lowers the volatility in portfolios generally.

The gold rush into private assets - much PE return has been a multiple expansion based on yields coming down. This space is likely to be compromised.

Quick implementation of tactical tilts by changing risk or yield targets. 150bps of alpha remains a target realistic.                                                                                                 

There is an unrelenting draw towards passive FI strategies but active with equity. Ability to generate alpha in fixed income is easier:

  • Term premia
  • Volatility premia
  • New issue premia
  • Convexity premia

It is more difficult as an equity stock picker. FI alpha comes from skill to harvest volatility. Identify and capture. Geopolitical volatility not just CB rates.

Where is inflation going? Market presumption that it’s returning to 0-2%. Frame of reference is what has been experienced in the past. An impression that the last decade represents some sort of normality.

Globalisation is likely to be replaced by a more multi-polar world. China/US relationship is likely to deteriorate.

The lower inflation of the last decade had two pillars:

  1. Globalisation
  2. Just in Time manufacturing and lean inventories (disinflationary) - the Just in Case model.

Key Takeaways:

  • The societal pressures for ESG. It does not come with zero cost
  • Changes in the labour supply function is now pushing wages
  • Share of GDP going to capital has been increasing. Median incomes have stagnated
  • Probable inflation rate of 2-4%: implies average cash rates moving from 2.5% with long dated yields at 3.25% >> equity multiples at 18x
  • However, if cash rates are at 3+% and long yields at 4+% >> equity multiples fall
  • Excessive confidence that the Fed with “do the job” and get inflation back to 0-2% >> implies no change in the long-term discount rate
  • Are markets operating with a degree of complacency? Fiscal dominance will likely persist
  • Governments are focused on short term electability leading to continued loose fiscal policy
  • USA is likely to slow down, but this has been masked by good weather in January and February. Expecting March data to be softer
  • Current buzzword is resilience. Mortgagees protected by refinancing when rates were ultra-low. Interest rate rises haven’t bitten the consumer as much as you might have thought
  • When rates go from 2% to 0 policy can be said to be ‘pushing on a string’. That may work the other way around: 0 to 2% “nobody notices, nobody cares”
  • Pushing up rates leads to financial conditions tightening. When financial conditions tighten this
  • leads to stress in the system: weak players will get found out
  • SPACS >> NFTs >> ‘Daft’ Banks (becoming giant hedge funds by buying long dated fixed income assets when they rates were at all-time lows)
  • European banks operating conditions are the best we have seen for a generation