Not all pluses are equal: the case for an active approach to fixed-income spread sectors

Key takeaways

• Fixed-income investors will face new challenges in 2022, including high inflation and tightening monetary policy, in addition to persistent ones, like low yields and tight spreads
• The temptation to reach for yield by increasing credit risk or extending duration is understandable, but often impractical and ill-advised
• Challenging markets like today’s are where active approaches can truly shine; we believe there are ample opportunities for investors able to first cast a wide net and then hone in on targeted segments of the bond market

The past year delivered a raft of new challenges for fixed-income investors in addition to the persistent headwinds that have characterized the market for several years. First, the familiar: Yields have remained practically nonexistent in many high-quality segments of the market, while spreads in riskier areas have returned to pre-pandemic levels and are again historically tight. Price signals continued to be unreliable indicators of risk as central banks—particularly the U.S. Federal Reserve (Fed)—continued the bond-buying programs that they began in the wake of the COVID-19 pandemic. As for the new pitfalls to navigate, inflation has returned with a vengeance, hitting a 40-year high in the United States as well as parts of Europe; meanwhile, the supply chain disruptions and labor-force shortages that contributed show no near-term signs of abating.

The Fed, for one example, seems to understand the inevitability of its next move and has recently begun to taper the volume of its monthly bond purchases; its consensus forecast, meanwhile, calls for about three rate hikes in 2022. Against this backdrop of stubbornly high inflation and increased monetary tightening, there’s also the prospect of slower economic growth. The consensus estimate for U.S. GDP growth in 2022 is 3.8%—a meaningful slowdown from 2021, although still above the longer-term trend.

The solution is not more risk—nor is it to avoid risk

The “easy” answer to these challenges would be to dial up risk in a fixed-income portfolio, increasing allocations to high-yield corporates or high-yielding emerging-market debt. Or one could reach for yield by extending duration—while crossing one’s fingers that moderating economic growth and inflation will be enough to keep longer-term rates from jumping materially higher. Of course, few institutional investors have the luxury of simply increasing their risk budget—particularly doing so because the market looks uninviting. But significantly dialing down risk is no winning formula either. Fixed-income investment mandates aren’t simply about playing defense. For any investor seeking to generate a certain level of income or total return, taking major overweight positions in, say, short-duration bonds or Treasury Inflation-Protected Securities isn’t a particularly attractive option, either.

Naturally, the course we advocate at Manulife Investment Management is an active one. Challenging markets like today’s call for pursuing targeted opportunities—and ideally, several of them in concert. In this piece, we’ll take a closer look at how we’re navigating some key areas of the market—particularly those beyond core sectors—and what tactics might serve investors well in light of the unique challenges of today’s bond markets.

Duration is not the enemy

One common presumption, even among seasoned investors, is that shorter-duration assets have offered protection during periods of monetary tightening. But history paints a somewhat different picture. Looking back on past tightening cycles in the United States can be particularly instructive. Between June 2004 and May 2005, the federal funds rate rose from 1.0% to 3.0% through a gradual series of quarter-point rate hikes. Yet the return for the Bloomberg U.S. Aggregate Bond Index during that time was nearly four times higher than the return for the Bloomberg 1–3 Year U.S. Aggregate Bond Index, a proxy for short-dated debt.

Challenging markets like today’s call for pursuing targeted opportunities—and ideally, several of them in concert.

The reason, of course, is that the shape of the yield curve often changes as monetary policy shifts from an accommodative stance to a tightening one, with different factors driving the two ends of the curve. The short end, as we know, is driven by the central bank’s policy concerns regarding inflation and the economy, while the long end is much more a reflection of market demand and investors’ appetite for risk. If a central bank is looking to tamp down inflation while investors are starting to wonder about a slowing economy, that’s a pretty good recipe for a flattening yield curve. And that’s exactly what we saw when the Fed started tightening in 2004, and again in 2016–2018. The key point here is that trying to predict the level of interest rates is a notoriously difficult undertaking and one that often offers limited upside. We think there’s much more to be gained by adjusting a portfolio to account for the shape or relative steepness of the curve.

Don’t wait on a rising tide to lift all corporate bonds

Corporate bonds are, for many investors, a key part of any “plus” allocation, and taking an active approach to that segment of the market is a good way to seek out incremental value. We believe we’re essentially mid-cycle in the United States as well as in much of the developed world and that tilting a portfolio toward consumer cyclicals over consumer staples makes sense. The economy still hasn’t fully emerged from the shadow of COVID lockdowns and we believe there’s still runway left in the so-called reopening trade as 2022 progresses.

We are mindful of valuations, however, with spreads in both investment grade and high yield extremely tight; there’s not a lot of room for widespread price appreciation. But there may be some: The fundamentals within much of the corporate bond landscape have been improving and upgrades have accelerated. Investors tend to focus on so-called rising stars—issues that get upgraded from the high-yield space to investment grade—but within just the investment-grade segment of the market, there’s been meaningful activity. In the third quarter of 2021 alone, upgrades outpaced downgrades by a huge margin: more than $100 billion versus just $14 billion. The upgrade/downgrade trend over the full year last year was about 1.6 to 1.0, which historically is a significant differential.

The other key point to remember about credit spreads is that they can move sideways for long stretches of time. Going back to a prior example, investment-grade credit spreads were rangebound for a full three years, trading at basically 80 to 100 basis points over U.S. Treasuries from mid 2004 to mid 2007. During that period—which featured clockwork short-term interest rate hikes—the investment-grade sleeve of the Agg generated an excess annualized return of around 87 basis points. An active allocation would’ve had the potential to exceed even that, and we’d argue that’s not a bad place to land from a risk/return perspective in an environment of steadily rising rates.

Patience and diligence can uncover opportunities in securitized debt

Sometimes opportunities can be hiding in plain sight; asset-backed securities (ABS) are one such example. The segment represents a relatively small part of the Agg and in benchmark-oriented strategies consists primarily of the most garden-variety ABS: auto loans and credit-card receivables, specifically.

But if investors are willing to roll up their sleeves and consider adding a bit of structural complexity, instead of just credit risk, there are attractive opportunities in many areas of the ABS market, including whole business securitizations, timeshares, single-family rentals, equipment leases, shipping container leasing, and more. These overlooked and underutilized segments of the market present some opportunity for incremental excess returns that aren’t as correlated with other pure credit segments of the market.

Another securitized segment worthy of a closer look is agency mortgage-backed securities (MBS). There’s an old adage to “own what the Fed is buying.” While we’re not sure that’s much of a bedrock for an investment strategy, the corollary is worth considering. As the Fed continues—and possibly accelerates—the tapering of its bond purchases (which include agency MBS), the drop in artificial demand could translate into higher yields—yields, in other words, more commensurate with the risks. We’ve been underwhelmed by the risk/reward profile in agency MBS for several years, but should yields in that space tick higher, the segment may merit closer attention from active investors.

International allocations provide diversification on multiple levels

While much of the developed world is marching to the same drummer when it comes to monetary policy and combatting inflation, the situation in emerging markets is a little different in some noteworthy ways. Inflationary pressures surfaced in a number of emerging markets quite a bit earlier that they did in the United States or Europe; central banks, in many cases, were also therefore quicker to act. Mexico, South Africa, South Korea, and Chile have all already begun raising short-term interest rates, just to name a few examples.

This discrepancy in timing—in when each central bank began the process of tightening policy—may seem like a small detail, but it can actually be the locus of some meaningful investment opportunities. South Korea, for example, began hiking interest rates in August 2021 and today its base rate stands where it did at the start of 2020. We believe the market has priced in more rate hikes this year than we believe are likely to be necessary. That kind of priced-in expectation for higher rates—if they don’t ultimately materialize—can create opportunities at the short end of the curve when expectations and reality reconverge.

While much of the developed world is marching to the same drummer when it comes to monetary policy and combatting inflation, the situation in emerging markets is a little different in some noteworthy ways.

Turning to South Africa, the central bank there began the process of normalizing rates in November 2021. But what makes that market appealing is that, nominally, 10-year debt is yielding more than 9%, with positive real yields of around 4%; and the yield curve in South Africa is already comparatively steep, with a more than 400 basis point difference between the 2- and 10-year bonds. In our minds, we believe the risk of meaningfully higher long-term rates or a steeper curve are more than offset by the incremental income offered.

Nuances are one thing; there are other countries that are at different points in the economic cycle, entirely—where there’s little to no inflationary pressure, economic activity needs a jumpstart, and the central bank is much more focused on implementing stimulative measures. The best example of this today is probably China. The PBoC has already cut rates twice in 2021, but we believe there’s a strong likelihood of further rate reductions in 2022. In the context of a global portfolio, adding that kind of macroeconomic diversification to the mix—where the trajectory of rates and monetary policy can serve as a tailwind—can be a big advantage.

Currency exposure can add uncorrelated alpha

Macro and fundamental-level diversification benefits aren’t all that international bonds bring to the table; tactical currency positioning remains one of the best diversification tools available to an investor. The question is, as always, how and where to pursue it.

One of the most straightforward ways to implement a bullish view on a currency is to own the country’s bonds outright. To stick with the China example, adding China government bonds to a U.S.-focused portfolio offers tremendous diversification benefits. The correlation between rates in the United States and China has historically been around 0.1, which means, directionally their movements have been essentially independent. And because foreign ownership of China bonds remains such a small percentage of the overall market, longer-term rates aren’t whipsawed by investor flows or risk-driven trades.

But owning a bond and its base currency are, ultimately, independent decisions. An investor can choose to buy a foreign-denominated bond based on attractive fundamentals and hedge away the currency risk. Or an investor can own a currency outright through FX positioning without buying the underlying bond. The hard part, of course, is deciding between the two.

There are many factors that affect whether a currency is strengthening or weakening—inflation, the economic trajectory, the direction of rates—but our research suggests that currencies tend to trend up and down over longer-term arcs that can last five years or more. So if you believe that the U.S. dollar may be near a bit of an inflection point—as we generally do—and that it could begin to transition from a strengthening cycle to a weakening one, that transition opens many doors for investors that are willing and able to implement a stance on currency in their portfolios.

Active management was built for challenging markets

With compressed spreads, high inflation, and tightening monetary policy part of the investment landscape in so many markets, it’s not a particularly bold stance to say that a passive, blanket allocation in fixed income might not be an ideal approach. Allow us, then, to put more of a stake in the ground by saying that for active managers with sufficient scale and global resources, there are abundant opportunities in today’s market. The key lies first in being able to effectively pursue them.

At Manulife Investment Management, our global fixed-income team is composed of more than 150 investment professionals on 10 distinct teams around the globe, from Boston to Beijing. Having that breadth and depth of talent and resources is a vital component of delivering results—especially in markets as challenging and nuanced as this one. The second key to capturing opportunities is to allow for a broader mandate. Opportunities do exist throughout the fixed-income universe, but a narrowly defined strategy—limited to, say, only U.S. investment-grade bonds or only EM sovereign debt—will by definition miss many of the most compelling pockets for generating potential alpha. We believe casting a wide net and broadening the opportunity set is always a good idea. Pairing that mindset with an active and targeted approach may be a luxury in certain markets; we’d argue in today’s market, it’s more of a necessity.