2024-09-23 05:06:33
Marco Giordano discusses why, in a more cyclical environment, fixed income investors can earn attractive income, if they reconsider widely held assumptions. Comment sponsored by Wellington Management.
SNAKE of Marco GiordanoInvestment Director, Wellington Management. Comment sponsored by Wellington Management.
We are convinced that, in a more cyclical period, fixed income investors can earn attractive income across the energy spectrum, although to do so they will need to closely review some of the assumptions that occur throughout.
Wouldn’t it be better to wait for the central banks to speak out?
Over the past two years, we have seen a large flow of money into cash and similar liquid assets, driven by the ability of these products to deliver strong returns with a low level of risk in an uncertain environment. Now, despite its appeal, this move is not without risks. Once a growing number of central banks start cutting rates, short-term rates will adjust rapidly. With each downturn, investors’ exposure to renewable risk will result in a constant decline in the interest generated by the assets.
Most importantly, high-quality debt, in addition to providing an income stream comparable to cash, provides collateral security if central banks make rate cuts in the near future. As proof, just look at what happened recently in the same period, where money has neglected the main fixed income categories after the start of the rate cuts.
Specifically, we look at the three-year total returns on money, Treasuries, corporate bonds, and short-term corporate bonds since the last rate hike in each of the Fed’s full tightening cycles since 1980. As Chart 1 shows, the returns of all fixed income strategies are significantly higher than cash. Although some bonds offer lower yields than cash, on average they have outperformed cash over the last six rate cut periods.
Chart 1. Average return in the three years after the last increase: money did the worst
Why is money worse at this point?
First, fixed income investors do not need to reinvest in a low rate environment as they have already locked in high returns. In the second place, The duration component of bonds tends to improve returns when the middle or length of the yield curve adjusts downward.. Finally, a prolonged period of rate cuts generally supports economic growth, which can lead to a narrowing of spreads that benefit corporate bond investors.
Although all categories of fixed income are higher quality in the example above than cash, long-term bonds tend to outperform short-term ones. However, We must remember that long-term bonds are associated with great volatility. If interest rate volatility is considered too risky, short-term strategies can produce a more favorable evolution on cash, while benefiting from changing yield cycles (with interest rates high height in the short end of the curve) and maintain a moderate exposure to rates, which means a small expected change.
Is it too late to invest in credit?
The fact is that credit spreads are declining in 2023, leaving little room for further decline. That said, we believe that debt spread yield will remain attractiveeven if there are no major repairs in a while.
The possibility of a major global recession seems out of fact, global purchasing managers’ indexes point to an acceleration of growth. Energy consumption is in a strong position, and companies show a good level of capitalization. Although we note some weaknesses in some sectors, we are confident that the credit cycle will last and we do not see a wall of developments that will force companies to re-pay altogether. At this point, spreads can be firm. In other words, since a special squeeze does not seem possible, why not take advantage of the debt spread, even if the cat is not as narrow as they did last year?
Advantages of an active approach versus a passive one
While our markets are stuck in the old regime of central bank intervention when pressures are too high, we believe the days of easy money are behind us. This can make passive portfolios more vulnerable to the negative impact of deteriorating credit conditions. A key area in which an active approach can benefit investors is the composition of indexes. Passive investment at the investment credit level connects investors to exposure to the sectors and issuers of the benchmark index. This can be a problem if investors show themselves unconsciously to the risks they would like to avoid, especially in a period characterized by cyclicality and variability.
The problems that the European real estate industry has recently faced are an example of this issue. In Europe, as in the rest of the world, the real estate sector has benefited greatly from low-interest rates. Between 2018 and 2022, the weight of this sector in the Bloomberg Euro Composite Index increased from 3.3 to 7.6%. However, once the effects of rising interest rates began to bite, the sector significantly underperformed the rest of the European industrial index. As a result, passive investors are particularly exposed to undesirable risks due to their involvement with heavy debt sectors and issuers.
In addition, active managers can detect rate reductions before they occur. At the end of 2021, the Bloomberg Euro Composite Index had 96 real estate issuers. By June 30, 2024, that number had dropped to 82, after some issuers suffered lower levels and indexed down. Basic analysis helps to active managers to identify credit damage or improvement before the rating agencies doand even before the expected change by the markets. In any case, high leverage should be a clear signal for credit unions to investigate a company’s earnings and free cash flow, its asset sale and distribution plans, and the level of commitment of its management team to the investment scale. -money.
We are sure that, in the new regime, fixed income investors can get attractive income that contributes to total returns across the spectrum of quality. To do this, it is important that old ideas do not have a way of success.
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Sources and notes:
The views expressed herein are those of the authors at the time of writing. Other parties may have different viewpoints and make different investment decisions. The value of your investment may be higher or lower than at the time of the original investment. Although the third party data used is considered reliable, accuracy is not guaranteed. Intended exclusively for professional, institutional or accredited investors.
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