Roadblocks on your path to higher yield

Economies are exiting crisis mode – and policy uncertainty is keeping fixed income investors on their toes. Central banks are moving away from overly accommodative monetary policy, but it is still unclear exactly where they are heading.

Today, bond investors must cope with the fact that when their holdings mature, reinvesting their money may mean investing at much lower yields. In many cases, they need to take on more risk to get a yield com­parable to that of the bond that has just matured.

Fixed income has historically been an attractive choice due to relatively stable returns and portfolio diversification benefits. Both of these qualities are more difficult to find in today's policy-driven, low-interest-rate environment – particularly as trillions of bonds are yielding less than zero.  

Although yields have spiked recently, the overall level is still low in historical terms. Our economists expect yields to trend higher over time, but the road could be bumpy.

Not all roads lead to yield – but what proven routes can you take?

There are choices available to those looking to invest wisely in fixed income opportunities. Here, we examine three viable options with analyses from our experts.

1. Cross-over debt

In today’s environment, our experts believe that avoiding the lowest credit quality is helpful for investors. This is because the return on such bonds very often does not justify their risk level. At the other end of the quality spectrum, the highest-quality debt simply does not offer much in yield anyway.

As such, choosing mod­erate credit risk in developed markets is practical – for example, having exposure to the cross-over space. This can mean opting for a combination of the lowest-quality investment-grade bonds and the high­est-quality high-yield bonds.

Our experts expect that crossover corporate debt will continue to benefit from still abundant liquidity and further declining default rates, which peaked at the end of 2020 and have decreased substantially since then.

Moreover, analysts continue to see a positive rating drift by credit rating agencies as the number of upgrades outweighs downgrades. In other words, we will likely see more 'rising stars' than 'fallen angels'.

2. Flexible income strategies

The days when the average holding period of a bond was at least eight years and investors pursued a buy-and-hold strategy in fixed income are long gone. Nowadays, investors with such a long investment horizon are probably more exposed to alternative credit strategies or hedge funds rather than traditional fixed income.

Today’s high volatility on fixed income markets is likely to stay, and investors may want to consider flexible fixed-income strategies across all segments to generate positive returns.

Looking at the first few weeks of 2022, yields have spiked massively around the world, following persistently high inflation read­ings and the chorus of calls for a faster reversal of the ultra-loose monetary policies of developed-market central banks.

The violent bear-flattening in the world’s biggest bond market, the US Treasury market, and the jump in volatility imply the market considers there to be an elevated risk of a policy mistake by the US central bank – e.g. simultaneously lifting its policy rate too quickly and reducing its balance sheet too rigorously.

We therefore believe that flexible income strategies should do well in this environment.

3. Alternative investments

Alternative funds can offer a new perspective on this dilemma facing fixed income inves­tors today.

Instead of taking on a disproportionally high level of credit and/or interest-rate (duration) risk to get the desired yield, investors can also consider hedge funds and long-only alternative credit strategies within the context of a diversi­fied portfolio.

A portfolio of hedge funds

A well-diversified portfolio of hedge funds has historically been able to replicate the risk and return observed in fixed income, more precisely in credit, without actually taking on significant credit or duration risk.

This return and risk simi­larity is purely synthetic and the result of volatility-re­ducing investment techniques.

In fact, a portfolio of hedge funds has been able to deliver returns at a volatility similar to diversified credit invest­ments without depending on the decade-long interest-rate rally for excess-return generation. However, investors should note that hedge funds come with their own set of risks, including tail risk and liquidity risk.

Alternative credit

Alternative credit is an interesting next step for clients who already have experience in investing in lower-quality high-yield bonds. Contrary to hedge funds, alternative credit solutions such as private credit, leveraged loans, direct lending, structured credit, and insurance-linked securities are all typically long-only.

The common theme across alter­native credit is that investors receive a certain illiquidity premium in addition to the typical spread earned for com­parable traditional credit risk.

The yield offered by private credit (leveraged loans and direct lending) is typically a combination of a floating interest rate tied to central bank policy rates, which explains the low duration risk of these instruments, and a credit spread/illiquidity premium.

The credit risk associated with leveraged loans and direct lending is considerable, as the borrower has a 'high-yield' rating or may even have no rating at all. To partially com­pensate for this elevated credit risk, the loans are typically high in the capital structure – and, in case of default, the lenders get served before other debt or equity holders. This does not mean, however, that investors are guaranteed a full recovery of their capital in case of default.

It's important to note that manager selection is even more important here than with more traditional strategies. Our experts believe that dedicated fund managers with specialised knowledge are the best way to access these opportunities.