Revisiting the three phases of fixed-income investing: where are we now?

“The only thing we can count on is uncertainty.”

―Albert Einstein

Fixed-income investing: where we were

In late 2022, coming off one of the worst periods for fixed-income investors, we wrote about the three phases of fixed income to help illustrate what we expected to see in the bond market over the coming years.

Phase one―the sweet spot

In this phase, investors should focus on the yield provided by the bond and enjoy “clipping the coupon.” That said, there’s no such thing as a free lunch―to obtain a higher yield, an investor must take on some sort of additional risk whether it be duration, credit, or even liquidity.

Phase two―duration is your friend

In the second phase, as the economy starts to weaken, we think it makes sense to begin to embrace longer duration and higher quality fixed-income instruments, such as 10-year U.S. government bonds. Duration is defined as the sensitivity of the price of a bond to interest rates. When the market begins to anticipate the end of a rate-hike cycle, yields across the U.S. Treasury curve tend to have already hit their peak, meaning that the downside risk associated with duration becomes minimal and the upside can be beneficial.

"Historically, forecasts about the number of defaults the markets may face are often overexaggerated." 

Phase three―take on risk

The final phase of the opportunity in fixed income takes place when investors want to take on risks when markets have fully priced in a recession. Typically, when that happens, high-yield corporate bond spreads will widen, indicating that the markets have factored in an elevated risk of corporate defaults. Historically, forecasts about the number of defaults the markets may face are often overexaggerated. This creates an opportunity for active managers―particularly those with deep credit research capabilities―to take advantage of dislocations between the expected default risk and what eventually transpires.

In phase three of fixed-income investing, taking on credit risk may be beneficial for investors. When the market realizes the error of its ways, credit spreads tend to tighten, a development that drives returns in high-yield bonds higher.

Where we are today

While we knew that the transition between phases will take some time, the expectation was that it would happen in somewhat of a linear fashion as it has in previous economic cycles. That, however, hasn’t been the case.

At the beginning of 2023, not many were predicting that the Fed would raise its rates to 5.50% or that the 10-year U.S. Treasury yield would sniff the 5.00% range―but that’s exactly what happened.¹ Furthermore, as we were heading into the fourth quarter of last year, the potential for the Fed to keep hiking rates couldn’t be ruled out. Had that happened, it would’ve placed even more pressure on fixed-income instruments with longer duration. Needless to say, the constant changing of expectations added volatility to part of the bond market that has historically been pretty steady.

Similar to how the Cboe Volatility Index measures the volatility of the S&P 500 Index, the ICE BofA MOVE Index measures the volatility of the U.S. Treasury curve. According to this index, we’ve experienced, since early 2022, the most volatility in the U.S. Treasury curve since the great financial crisis of 2008/2009. Daunting as it may seem, this level of volatility can offer active managers the opportunity to take advantage of dislocations in the fixed-income market in a manner that’s not dissimilar to how equity managers would typically look for undervalued equities during periods of wild market swings.

Market expectations surrounding U.S. inflation and economic data as well as Fed policy have been the main drivers of this volatility. In fact, coming into 2024, the belief among many in the investment community was that the inflation and economic data would be soft enough to allow the Fed to cut interest rates six times in 25-basis-point increments during the course of the year.

That, of course, hasn’t been the case as sticky inflation and a resilient economy kept the Fed on the sidelines, causing additional volatility over the course of the first four months of this year. Only recently has market expectations reacted to what economic data has been telling us and repriced accordingly. That said, we believe that the pendulum may have swung too far, with the market now expecting to see less than the equivalent of two full rate cuts in 2024 with the first not materializing until November.

The global picture, however, is slightly different as central bank policies diverge. Our colleague, Chris Chapman, head of global multi-sector fixed income, recently noted that opportunities haven’t necessarily been diminished despite the rise in uncertainty. According to him, flexibility is key.

“Prospects for rate cuts and slower growth across many global economies have created new opportunities across many segments of fixed income; however, like any economic forecast, the future remains uncertain. This is why fixed-income investors need to be flexible," said Chris.

“With global central banks at different stages in their monetary policy cycles, a tactical approach to managing interest-rate risk is crucial to navigating the uncertainties, and subsequent volatility, that lies ahead. Currently, we’re finding pockets of value across global interest rates from a risk/reward perspective where we believe local central banks could lead the Fed in terms of easing monetary policy or where markets aren’t yet expecting a dovish turn in policy over the next year.”

Pinpointing a specific spot where we are in the three phases has proved difficult. When it comes to trying to decipher which phase we’re solidly in, we realized that the current environment points more to a blend of phase one and two, rather than either/or. Yields across different fixed-income asset classes remain historically elevated and the average price for these assets remains well below par (typically $100).¹ Meanwhile, cracks in the seemingly resilient economy (in the form of weaker-than-hoped economic data) and slowing inflation are starting to put downward pressure on government bond yields favouring duration.

Another of our colleagues, Roshan Thiru, head, Canadian fixed income, said it well when he wrote about the golden age of security selection in fixed income: “The fixed-income market is deep and diverse, and there will always be pockets of opportunity for astute active managers to seize, regardless of the underlying economic environment. We believe, however, that due to current conditions (elevated and volatile interest rates), these opportunities are multiplied and amplified, favoring active management even more.”

In our view, the flexibility needed to navigate the current fixed-income landscape may even need to go beyond the traditional tools. In a recent article about nontraditional fixed-income investing, we used an analogy to help explain the concept: “If traditional fixed-income strategies were basic soundbars that played music in stereo, alternative fixed-income strategies would be like their more sophisticated cousins that allow you to adjust the level of bass, mid, and treble to create a more dynamic sound stage without destroying your eardrums. It’s all about having access to the individual levers that enable users to control what they hear.”

Although the outlook for investing remains uncertain, we can embrace that uncertainty in our fixed-income allocations by taking a flexible but well-thought-out approach to achieve the desired goal.

1 Bloomberg, as of 5/3/24.