Not all bonds are created equal amidst rate hikes

Tightening rates globally mean a diversified, actively-managed fixed income portfolio is more necessary now than ever for investors.

Not All Bonds Are Created Equal Amidst Rate Hikes
Iain Stealey shows yield data, says now is the best time for investors to be reconsidering fixed income in 15 years.

With rate hikes the quickest they’ve been in decades to combat global inflation, a Chief Investment Officer (CIO) at JP Morgan Asset Management has said that bonds are back — and ready to reclaim their role as portfolio-diversifier and income-generator amidst the difficulties of 2023.

Speaking at the Morningstar Investment Conference UK, held earlier this week in London, Iain Stealey, International CIO, Global Fixed Income, JP Morgan Asset Management, said that a turbulent macroeconomic environment plagued by tightening monetary policy throughout the West means that diversification is key when it comes to fixed income allocation.

Stealey was a strong advocate for the asset class’s viability, opening his discussion by declaring that “it’s the best time to be speaking about fixed income in 15 years.”

This sentiment was echoed in Dodge & Cox’s January 2023 paper on fixed income investment viability, tellingly titled ‘A new dawn for fixed income’. Its authors said they saw a “substantial silver lining in the cloud that has hung over the bond market over the past year”. The “cumulative interest rate increases that drove record annual losses have simultaneously returned the asset class to greater relevance going forward,” the report added.

As a central and necessary liquidity source for insurance investment teams, in particular – as well as an income generator, provider of capital preservation, and diversification mechanism when combined with riskier asset classes like equities and even real estate – fixed income always has a lot to offer. For investment teams at insurance organisations, its core relevance will likely never falter, however, keeping up to date on key trends can only benefit portfolios.

Rate hike end-game?

Stealey said he felt that there was a “fantastic environment now” for a thoroughly – and globally – diversified bond portfolio, due to the trend of increasingly tightening monetary policies of central banks, such as the European Central Bank (ECB), Bank of England (BoE), and US Federal Reserve (the Fed).

When asked, ‘why now?’, Stealey said that it feels like the “end-game” from central banks is getting nearer, and whilst inflation is still the biggest concern, “it is slowly rolling over”.

“The good news is that the market has repriced [inflation], so it’s a
great time to think about active management.”

“The good news is that the market has repriced it, so it’s a great time to think about active management. Consider even the Fed’s recent pause,” he added, referring to the recent increase halt by US Federal Reserve Chair Jerome “Jay” Powell. “The Fed is the biggest central bank in the world; when it starts cutting rates, the rest of the world stars cutting,” he continued.

This sentiment was at odds with what US insurance investment leaders said was top of their minds at the inaugural Insurance Investor Live | Midwest event last week in Chicago. Discussing their worries for H2 2023 during a panel debate, they did not share Stealey’s confidence that the Fed would cease rate hikes come late summer and early autumn.

Bob Cataldo, Chief Investment Officer at United Fire Group, the Iowa-headquartered P&C insurer, said that he thought a forced recession from the Fed was extremely unlikely. “It would signal Powell’s early retirement,” he said. “The Fed is serious about their fight against inflation, and rates will stay higher for longer. That’s okay, because of the short-term opportunities it allows. But we can continue to expect tightening.”

Stealey, however, felt that inflation was already priced into fixed income markets. "You have to consider real yields on government bonds as well as what the market thinks the effect of inflation will be on the life of that bond," he said, noting that there was repricing across all bond sectors.

“Fixed income is designed to be a ballast for times when
risk assets are suffering.”

“But it’s not just the repricing that’s important,” he continued. “It’s also important to consider what fixed income is designed to do in portfolios. It’s supposed to be a ballast for times when risk assets are suffering.” Whereas cash, another option for increased liquidity holdings in portfolios, “underperforms bonds 100% of the time.”

MBS, corporates, private credit a go

Looking at the forecast in the US, Stealey recommended specific debt vehicles, such as agency mortgage-backed securities (MBS), which he said were high quality loans that came with a government guarantee.

“I think of them as cheap US Treasuries,” he explained, noting that markets are seeing the widest spread since the Great Financial Crisis between mortgage loans and high quality core fixed income.

“Silicon Valley Bank had mortgages on its books that the Federal
Deposit Insurance Corporation needs to now sell down.”

“It’s a very compelling picture for where we want to invest,” he added. “For example, Silicon Valley Bank (SVB) had mortgages on its books that the Federal Deposit Insurance Corporation (FDIC) needs to now sell down.”

The other debt instruments catching Stealey’s attention were corporate bonds and private credit. “I’ve never seen corporations in such good health going into a downturn,” he said, adding that he saw Investment Grade (IG) private credit benefitting most from the grab for high-quality fixed income.

“This is where we’re actually seeing flows this year. Corporates, particularly high quality ones, are in good health. So they’re our recommendation for allocation this year,” he continued.

It was partially a waiting game, was one of Stealey’s main points – and he said high yield opportunities would likely arise later in H2 2023. This was largely because regional banks, in the US at least, weren’t doing much credit lending in the wake of failures this winter.

Green bonds are in

Stealey also advocated for the sustainable bond market, which he said was “definitely picking up”. Fixed income vehicles tailored around ESG considerations were once a niche market, but now no more. “What was once planning is now increased allocation,” Stealey said. “The sustainable bond market has grown to be mainstream.”

“There are different shades of green, and you need to ask what
will actually make an impact.”

Still, he cautioned against correlating ‘green’ bonds with impact. “There are different shades of green, and you need to ask what will actually make an impact. You could argue that there should be more regulation around labelling,” he said, skirting an outright regime admonishment. “There’s yield [with green bonds] that we haven’t seen in ages,” was his takeaway.

For investment teams at insurance organisations, infrastructure investment – such as US municipal “muni” bonds – could be an increasingly attractive option whilst inflation remains high.

Whilst muni bonds have long been a mainstay for US insurers, they are less prominent elsewhere, typically because they have historically been thought of as income-tax-exempt securities on purely a federal level. This is true for the bulk of the market, but there is a growing faction that does provide taxable income.

Diversification, diversification, diversification

Stealey’s message was that a globally diversified fixed income portfolio that capitalised on short and long-term opportunities – due to the inverted yield curve – and incorporated different sectors with varied kinds of underlying debt investments, could only be beneficial going forward.

To stay on top of turbulent macroeconomic conditions and fully capitalise on the hidden benefits of tightening monetary policy, investment teams at insurance companies will likely be readjusting their portfolios accordingly.