Investing textbooks and journals all promote the doctrine that bonds are safe and equities are risky, but 2022 has reminded everyone that bonds can be very risky too. It’s becoming increasingly clear that we are living in a tail risk world where serial once-in-a-lifetime events have and will continue to challenge investors like never before. Whether they like it or not, a very challenging macro environment has pushed all investors out on the risk spectrum.

In January 2021, we published a white paper called What is the Future of Income? We did so because we saw that investors were facing an “income famine” due to historically low interest rates caused by policymakers’ aggressive response to the COVID crisis. We predicted that the 40-year trend of declining rates was about to end and that the typically boring 40% in a traditional 60/40 balanced portfolio was going to be challenged. The significant tailwind of declining rates that caused many investors to manage their fixed income allocation passively was going to require they revive long atrophied skills. We hate to say that we told you so but….  

Fast forward to the present and 2022 was the worst showing for both equities and fixed income in years; so much for bonds being a reliable hedge against equity risk. Numerous unanswered questions remain, making this the perfect time to revisit the questions we posed two years ago. 

Although nominal interest rates are now much higher than they were then, most real rates remain in negative territory because inflation has spiked to levels not seen in decades. No doubt, inflation will moderate, in part due to extremely hawkish central bank policy, but it will take time to settle back to the target level of 2%. 

In our original paper we spoke of the challenge of generating income in a low-rate environment while investors were becoming progressively more risk-averse. Even though interest rates and yields have improved, the trend toward conservatism has also likely accelerated because of the war in Ukraine and the prospect of a looming recession. Whatever relief asset managers gained on the yield side has been more than offset by the uncertainties of a challenging macro environment.

We postulated that conventional approaches to generating income would not be sufficient going forward. Let’s see how that prediction panned out with respect to what we said, what happened and what we now think.

GICs

At first glance, the rise in interest rates has made GICs more attractive to consumers with one-year contracts paying over 4% for the first time in years. Looking beyond the obvious, it’s clear that, even at these more attractive nominal rates, buyers are still locking in negative real returns. As we mentioned, GICs are still unfavourably taxed at marginal rates, and they also eliminate optionality for participating in equity markets when they recover. 

No doubt there are situations where it is prudent to recommend GICs. Nevertheless, endorsing savings products remains patently off brand for investment advisors.

Treasuries

Although the risk of a capital loss is much lower now, volatility is much higher because the market is still trying to find an equilibrium. Many questions remain unanswered. Are we getting a recession? If so, how deep or shallow will it be? What happens to inflation & growth and the tradeoffs that policymakers will have to make? There is a very delicate dance going on in bond land right now since good news on the economic front would likely mean bad news coming from policymakers in the form of higher rates.

Although treasuries are more attractive now than they were in early-2021, the long end of the curve is still not compensating investors for the incremental level of risk.

Dividend Paying Equities

Most companies have thus far been able to maintain their dividends while rising rates have caused a decline in equity multiples. This is a fertile environment for investors because prices have dropped for the same level of dividends, meaning sharply higher dividend yields. Dividend paying stocks also tend to align with the value factor, which should be more resilient than growth stocks in an inflationary environment.

Going forward, the big question is can companies maintain their dividend in the face of a looming recession.

Investment Grade & High Yield Corporate Debt

Corporate bonds had their worst first half ever due to inflation and recession fears. Despite strong corporate fundamentals, historically low default rates are likely going to tick higher because of tighter financial conditions and decelerating economic growth.  There remain areas of the market which offer an attractive spread above treasuries; especially amongst US sub-investment grade issuers who opportunistically refinanced and extended maturities while interest rates were still at extreme lows. 

Selectivity is key to ensure that investors get adequately compensated for the heightened default risk.

NEW(ER) POSSIBILITIES FOR GENERATING INCOME

In our original paper, we proposed three ways investors could complement traditional approaches to generate higher, more predictable fixed income returns.

Let’s revisit those strategies but with a slightly different lens. Generating income and making income payments to investors are two different things. Fixed income securities produce income, but income payments can be made from any source of returns, or even a return of capital. Income investors want a reliable source of income, however, they are largely ambivalent as to the source of that income, provided it does not take them outside of their risk profile.

Emerging Markets Debt

EM debt, especially local currency debt, has been a good investment and an extremely important source of real yields for fixed income investors. EM remains the growth driver for the world with younger, growing populations and middle-classes. Although there are fewer easily accessible investment options than in other asset categories, one must still have a deep understanding of this segment of the market.

EM debt continues to offer attractive yields and remains a very important risk management tool.

Currency Effect

In our earlier report we signaled that the U.S. dollar had begun a long-term secular downtrend. That was true until the war in Ukraine validated the dollar’s safe haven status as an asset people want to hold in times of crisis. In part due to widening interest rate differentials, the British pound, Japanese yen, and euro have all made extreme moves to the downside versus the dollar. Investors must be cognizant of the implications of these moves while also recognizing the long-term fundamental overvaluation of the dollar. 

Although currencies can diverge from fundamentals for extended periods of time, actively modulating those exposures has become an important tool for managing risk and delivering alpha.

Active Management

Rates have finally begun to normalize, and bonds are once again starting to offer attractive yields, but this has come with a higher degree of volatility. Modulating cash exposure has historically been the ultimate risk management tool in a rising rate environment and getting the right call between growth and inflation is going to be key. 

In future, income investors may not have to go as far out on the risk spectrum to generate yield, but a difficult macro environment will mandate their full attention. 

Summary

Asset managers reeling from a difficult market in 2022 will have to pick themselves up, dust themselves off and start over again with a much more active and involved approach to fixed income than in the past. This will mean active cash management, active country and regional exposures, active duration management, active credit management and active currency management. 

Two years on from our original report, we maintain that investors should not give up on income, rather, they should explore new methods of sourcing income to complement the traditional approaches. Portfolio construction and tactical positioning are even more important in the face of serial economic, geopolitical, and environmental tail risks. The “set-it-and-forget-it” approach to fixed income management developed over the course of a forty-year trend of declining rates is even more dangerous than when we wrote our original report.