Categories
Fixed Income
The role of fixed income
Flavio Carpenzano
Fixed Income Investment Director
KEY TAKEAWAYS
  • Bonds can offer a variety of outcomes depending on different investors’ needs and their risk appetite.
  • Investment-grade corporate bonds can be viewed as a core allocation in a portfolio, as they have the potential to provide both income and downside protection.
  • Upcoming volatility, monetary policy normalisation and increased geopolitical risk could help make the case for a flexible and active approach to investing.

Introduction


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


3. Income


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.


 


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 17 years of industry experience and has been with Capital Group for one year. He holds a master's degree in finance and economics from Università Bocconi. Flavio is based in London.  


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Past results are not a guarantee of future results. 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. This information is not intended to provide investment, tax or other advice, or to be a solicitation to buy or sell any securities.

Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. All information is as at the date indicated unless otherwise stated. Some information may have been obtained from third parties, and as such the reliability of that information is not guaranteed.