Investing in fixed income has lost its appeal for many investors in a world where inflation is overshadowing bond markets, central banks are hiking interest rates and returns look relatively uninspiring. With that in mind, now’s a perfect time to revisit the question: why invest in fixed income?
In those moments of uncertainty and heightened volatility, it is important to stop and reflect on the basic role of fixed income and its overall impact on portfolio allocation. While the primary objective of investing in equity is capital growth, fixed income helps serve four key roles in a portfolio: capital preservation, income generation, inflation protection and diversification away from equities. As a fixed income investor, it is crucial to focus on the return of capital rather than the return on capital.
Although the opportunities for returns in a low yielding environment are harder to find, it is important to remember that the bond market is by far the largest securities market in the world. The market has grown tremendously both in terms of size and number of issuers, creating many investment opportunities.
Growth of major bond indices
Data as at 31 December 2021. Date of inception for indices listed is 31 July 2001 (31 July 2002 for Emerging Markets Hard Currency and 31 January 2006 for Emerging Markets Local Currency). Global Treasuries: Bloomberg Global Aggregate Treasuries, Global Investment Grade Corporate: Bloomberg Global Aggregate Corporate, Global High Yield: Bloomberg Global High Yield, Global Inflation Linked: Bloomberg Global Inflation Linked Total Return Index, Emerging Markets Hard Currency: JPMorgan EMBI Global Diversified Total Return Index, Emerging Markets Local Currency: JPMorgan GBI-EM Global Diversified Total Return Index, Global Securitized: Bloomberg Global Aggregate Securitized. Sources: Bloomberg, JPMorgan
As mentioned above, bonds serve four key roles:
1. Capital preservation
2. Diversification from equity
4. Inflation protection
Each asset class can provide a different outcome
For illustrative purposes only. Investors cannot invest directly in an index.
Data as at 9 February 2022. IG: investment grade. HY: high yield. EMD: emerging market debt. HY/EMD is 50% US HY and 50% EM hard currency. TIPS: Treasury Inflation Protected Securities. Diversification is based on the duration of the asset class. Inflation protection is based on the asset classes’ correlation to TIPS. Income is based on the nominal yield for each asset class and capital preservation is based on the asset classes’ 5-year volatility. Data has been rescaled and ranked using percentiles. Indices (left to right): Bloomberg Global Aggregate Treasuries Total Return Index, Bloomberg Global Aggregate Corporate Total Return Index, Bloomberg US Corporate High Yield 2% Issuer Capped Total Return Index, JPMorgan EMBI Global Total Return Index and Bloomberg US Treasury Inflation Notes Total Return Index. Source: BlackRock Aladdin
The different fixed income asset classes such as developed and emerging market government bonds, investment grade and high yield corporate bonds and inflation linked bonds, can provide various outcomes for investors. For example, relative to the other asset classes, global Treasury bonds could offer an effective hedge against equity exposure in portfolios, given their generally steeper yield curves and longer duration position. On the other hand, high yield and emerging market bonds are better suited to fulfilling the role of income generation, given the higher nominal yield present in these markets.
1. High quality government bonds offer tail risk hedging and potential downside protection
Investors have typically used fixed income to offer protection during equity bear markets. However, the correlation between equity and fixed income markets has increased recently, which led to many questioning the role of fixed income in a portfolio. While we acknowledge that there have been periods when the correlation between the two asset classes was positive, if we take a long-term perspective then more often than not, equities and high quality government bonds have shown a negative correlation. Therefore, increasing the fixed income allocation in a portfolio could help mitigate downside risk.
Tail events are generally difficult to predict, so protection from tail events can be a valuable component of a diverse portfolio. In periods of market stress with sharp equity market correction, high quality government bonds, particularly the longer dated bonds, have continued to provide real downside protection, even with very low or negative yields such as those seen in Europe.
High quality bonds have shown resilience when stock markets are unsettled
Past results are not a guarantee of future results.
Data as at 31 December 2021. LHS: Cumulative returns shown. Indices (left to right): EURO STOXX Index, S&P 500 Total Return Index, Bloomberg Euro Treasury Germany 20+Yr Total Return Index and Bloomberg US Treasury 20+Yr Total Return Index in local currency terms. Global financial crisis: 9 October 2007 – 9 March 2009. Flash crash: 24 April 2010 – 2 July 2010. US debt downgrade: 2 May 2011 – 3 October 2011. Oil price shock: 4 November 2015 – 11 February 2016. Global sell-off: 21 September 2018 – 24 December 2018. COVID-19 crash: 20 February 2020 – 23 March 2020. Source: Bloomberg
Consider the current market environment where inflation is high, and many central banks are embarking on interest rate hiking campaigns. High quality government bonds tend to underperform alongside expected rate hikes as yields tend to increase. However, yields on short-term bonds tend to increase the most, while at the longer end of the curve (10 years and out), the upward movement in yields is far more muted. This is because the purpose of rate hikes is to curb excess demand and suppress inflation, which in turn dampens inflation expectations. Read our full paper on fixed income and rising rates here: Fixed income and rising rates
Overall, although the market tries to find alternatives to high quality government bonds as a form of tail risk hedging, we think they remain the most liquid, simplest and effective instrument relative to other opportunities such as options-based or long-short equity strategies.
Read the full article
Risk factors you should consider before investing:
- This material is not intended to provide investment advice or be considered a personal recommendation.
- The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
- Past results are not a guide to future results.
- If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
- Depending on the strategy, risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.
Flavio Carpenzano is an investment director at Capital Group. He has 18 years of industry experience and has been with Capital Group for two years. He holds a master's degree in finance and economics from Università Bocconi. Flavio is based in London.
I'm Flavio Carpenzano, an investment director at Capital Group with 18 years of experience in the field. I hold a master's degree in finance and economics from Università Bocconi and have been with Capital Group for the past two years. My expertise lies in fixed income investments, and I have a deep understanding of the dynamics within bond markets, especially in the context of the current economic landscape.
Now, let's delve into the concepts covered in the article about investing in fixed income. In a world where inflation is impacting bond markets and central banks are raising interest rates, the appeal of fixed income has waned for some investors. However, it's crucial to revisit the question: why invest in fixed income?
The article highlights four key roles that fixed income plays in a portfolio:
Capital Preservation: Fixed income serves as a tool for preserving capital, especially in moments of uncertainty and heightened volatility. Focusing on the return of capital is emphasized over the return on capital.
Diversification from Equity: Fixed income provides diversification away from equities, helping to balance a portfolio and mitigate downside risk during equity bear markets.
Income Generation: Despite challenges in a low-yield environment, fixed income, particularly high yield and emerging market bonds, can offer income generation opportunities with higher nominal yields.
Inflation Protection: Different fixed income asset classes, such as inflation-linked bonds, can provide protection against inflation. The article mentions that global Treasury bonds may offer an effective hedge against equity exposure due to their steeper yield curves and longer duration position.
Additionally, the article discusses the growth of major bond indices, showcasing the size and number of issuers in the bond market. It emphasizes the diverse outcomes that various fixed income asset classes, including developed and emerging market government bonds, investment grade, and high yield corporate bonds, can offer to investors.
The importance of high-quality government bonds in providing tail risk hedging and potential downside protection during market stress is highlighted. Despite concerns about their performance during interest rate hikes, the article suggests that longer-dated high-quality bonds have historically shown resilience and downside protection.
In conclusion, the article suggests that fixed income, despite its current challenges, remains a vital component of a diverse portfolio, offering capital preservation, diversification, income, and inflation protection.
Feel free to ask if you have any specific questions or if you'd like more insights into a particular aspect of fixed income investing.