Tightening Mode - Risks and opportunities in fixed income

12 October 2023

Emerging MarketsEquity releaseFixed IncomeGatekeeperGatekeepersInflationInterest

Expert: Peter Fitzgerald, CIO Multi Asset & Macro, Aviva Investors Moderator: Sam Shaw, independent consultant/freelance journalist


  1. Fixed income is typically used as a diversifier to equities, or to seek lower-risk returns, but the characteristics of fixed income have changed, which has made things more challenging, including higher-yield credit used in place of equities
  2. Duration has, broadly speaking, been trending down across portfolios as a risk-off strategy
  3. Inflation expectations are set to remain higher for longer amid a regime shift; fiscal spending is the main factor
  4. The issue is that the markets are already pricing cuts in for next year


Most gatekeepers said they use fixed income for counterbalancing equity exposure but inverse correlations with equities have been lacking over the past year or so, presenting a challenging environment for fixed income investors. 

Some also said they looked to bonds to offer their lower-risk, lower-volatility returns, which has been tricky to justify, given where cash rates had moved to this year.

The broad consensus was that FI has become a more exciting asset class than it has been for some time. For those using risk-targeted or risk-based models, holding lower-risk government bonds lost investors the most money last year.

Fixed income has been a relatively low volatile asset class but it’s not anymore. The team has been debating how to adjust some of its investment processes to accommodate more volatile rates.

With equities looking overpriced and the spreads available on high yield, one delegate said: “We’re now overweight fixed income on our model portfolios, and we're trying to work out whether we can sell more equity in exchange for the same risk in high yield.”

High-yield credit offers a significant pick-up in yield over lower-risk front-end, shorter duration government bonds. The longer-duration assets also mean the yields are being locked in for longer.

Duration has, broadly speaking, been trending down across portfolios as a risk-off strategy

Most investors have only experienced an environment where rates have been falling, not one where they've been trending upwards. 10-year Treasury yields at 4.85% looked tempting but when UK cash accounts were offering 6%, that total return looks more attractive.

The Aviva team has dipped toes into long-duration but has been more tactical than it has been historically.

Gatekeepers said they favoured investors with the flexibility to take a shorter duration in the funds they choose. Has been a widely held view as the group has been waiting for interest rates to rise.

Inflation expectations are set to remain higher for longer amid a regime shift; fiscal spending is the main factor. Peter said: “We are not in the 70s, but we’re certainly not back to the Great Moderation where inflation miraculously falls back to the central bank's target at 2% and yields can be can be cut.”

If there is a regime change, interest rates are going to be structurally higher, and a cut will only happen because of growth falling over. There is a case to be made for duration as your ‘risk-off’ strategy but it's not as clear cut, as it has been.

Speaking to policymakers across inflation reduction, infrastructure, climate change, etc, they are so broad-reaching, and they’ve tackled it through tax reductions, rather than subsidies – ‘bailing in’ and incentivising private investment.

Consider deglobalisation and all the associated risks – for the past 20 years, inflation has been steady around 2% but now factoring in tariffs, reshoring, trade barriers and a shift to ‘just in case’ rather than ‘just in time’ manufacturing (different approaches to managing inventory in line with production schedules), you can see how global inflation will creep upwards.

Japan is currently dominating Aviva’s short positions – more so than any market the team has ever held, as Peter explained:

“We put the position almost two years ago, when 10-year rates were 25 basis points, which did reasonably well.

“Following a research trip earlier this year, the team reduced all their positions because we had no confidence they were going to move on policy.

“We cut long yen, we reduced the size of our rates positions but over the last couple of months, we've increased them all back up to maximum size (short across 10-year and five-year). They are running 4% inflation six to nine months behind the rest of the developed world; they have negative interest rates and wonder why their currency is weak?”

Is there a need to strengthen the currency? It pleases the exporters; it brings in the tourists. What would be the incentive?

Politicians and the Japanese public are concerned about the weak yen because of the inflationary impact it can bring. They will slowly intervene in the currency market – using interest rates – to slow the decline at the other end. The biggest concern for politicians and the finance ministry is that if they move away from zero interest rates, they will not be able to fund their budget deficit.

He said: “I can make money by just being short front-end rates in the US, if nothing changes. The asymmetry is not in my favour short term, but I get paid 80 basis points if there's no change because there's almost 1% priced in for the Fed to cut next year. I need them to cut rates, particularly as I'm talking about the front end.”

Key takeaways:

  • The Fed is expected to take rates from c.5% to 4% next year, the Bank of England is expected to cut rates by 80 basis points – but it changes every day – the problem is the market is already expecting cuts
  • Evolving characteristics, shifting global dynamics, and uncertain interest rate environments are influencing investment strategies, prompting a re-evaluation of traditional risk-off approaches and diversification tactics
  • There is need adaptability and a nuanced understanding of global macroeconomic factors in navigating the evolving fixed income landscape