Global equities, as measured by the MSCI World Index, have delivered an annualised return of about 5.25 per cent since 2000. Not bad, but when investors can lock in coupon payments that match historical equity returns without equity risk factors, we think we are in a new golden age for bonds.
Corporate bond yields began climbing rapidly at the start of 2022, creating difficulty for many market participants. However, the rise in yields may set the stage for bond investors to reap higher levels of income than previously available. That’s because 70 per cent of investment-grade corporate bonds and 75 per cent of high-yield bonds were issued before 2022. While a bond investor should care about yield and not typically make issuance year a focus, this dynamic provides some cushion of safety to bond investors.
Here’s why: currently, the average investment grade corporate yield, as measured by the S&P Global Developed Corporate Bond Index, is around 5 per cent. Meanwhile, high-yield corporate bonds yield around 8 per cent, as measured by the S&P US Dollar Global High Yield Corporate Bond Index, while AAA corporate bonds currently out-yield global equities at around 5.1 per cent versus 1.9 per cent. However, the average investment grade corporate issuer is paying around a 4 per cent coupon.
This sets up a win-win for bond investors and the companies in which they invest: a win for the investor because they can harvest today’s higher yields from high-quality companies, and for many corporations as they can comfortably service their debts at pre-2022 coupon levels.
That’s why we believe now is the time to go active in fixed income. The rise of passive investing in the last decade has dramatically reduced the cost of investing in bonds. It has also created significant inefficiencies for active bond investors to exploit, as comparatively less active money has been available to arbitrage away relative or absolute value opportunities.
A key risk for passive bond investing is that fixed-income benchmarks are fundamentally flawed in a way that equity indexes aren’t. Unlike equity indexes, bond indexes tend to apply weightings based on debt outstanding. This can mean passive bond investors are unintentionally overweight and overexposed to more heavily indebted companies. An active investor can generally seek to avoid this scenario, particularly in an environment where growth may be challenged, calling into question the creditworthiness of the most indebted borrowers.
Therefore, we believe current market conditions are ripe for exploitation by proven active fixed-income managers that can capitalise on today’s market inefficiencies while protecting principal.
Active Fixed Income in 2024
We believe an active approach to bond investing allows investors to take more intentional tilts in favour of bonds backed by companies with strong credit characteristics and those at an attractive valuation, among other risk factor tilts. A savvy bond investor can also exploit the many inefficiencies that arise from large index-tracking strategies that are focused on closely tracking a benchmark, rather than risk-adjusted return generation. Consider, for example, actively managed multi-sector fixed-income strategies that offer yield and some shelter from volatility. Additionally, a strategy focused on a single sector such as high-yield bonds can offer equity-like returns with a lower risk profile than stocks.
Targeting inefficiencies effectively means casting a wide net across the fixed-income universe, including corporates, governments, municipals, mortgage-backed securities, global bonds, emerging markets, and structured credit, and combining the best opportunities with precise risk scaling. As economic growth is expected to slow, managers also need robust credit analysis capabilities, not just across corporate bonds but all forms of bonds, which requires extensive resourcing commitments.
Market inefficiencies are often durable but not large. Most notably, the risk premium available on individual bonds can be inefficiently priced, allowing credit-focused managers to target multiple security-selection opportunities. Unfortunately, some strategies might be just too large to implement a meaningful security-selection position based on the volume of bonds outstanding. As a result, we find the largest bond funds are often overly reliant on duration positioning, which can be very volatile.
We believe managers need to be resourceful enough to find inefficiencies across the whole fixed-income universe, such as employing credit analysts across the globe to cover issuers in their local market. However, they also need to be nimble to have any hope of exploiting them (for example, by managing strategies small enough to take a security or sector-selection position that can have a meaningful impact on performance).
Bonds might lack the glamour and buzz of many of the investment trends of the last decade, but they have the income, return, risk profile and staying power many are seeking. Welcome to the new golden age of bond investing.
Adam Whiteley, head of global credit, Insight Investment
